Analysis of Cash Flow for a Small Business - Assignment Example

Running head: Cash Flow Analysis for a Small Business Applying the EBIT Formula to a Small Business Cash Flow as an Indicator of Profitability The complexity of cash flow depends on the complexity of the business. In the case of what Charles is doing, there are not many accounts to worry about other than income, depreciation, and expense. This kind of cash flow falls under the category known as EBIT that stands for earnings before interest and taxes. According to Bodie et al (2004), it is the amount arrived at as a difference between income and expenses.

Mils et al (2002) call the flow of cash into a business and out of a business, in a form of income and payment ‘cash flow’. Another source Tarter calls EBIT a useful tool for measuring cash flow. Wallick (2009) on the other had states that in bigger businesses, there is a clear difference between EBIT and cash flow. The standard formula for EBIT that is applicable here is EBIT = Revenue – Operating Expenses (Investopedia).In the case of Charles, the various expenses, depreciation, and income had been given for the two years he was in business.

Secondly Charles’ concern is his not generating enough income after investing two years in the business and he is contemplating to take a job that would pay him $40,000. Since he was in business for only two years and the second year was better than the first, the first area to look at will be the yearly percentage increase on Charles’ income and the following calculation will show that.65000-25000=40000/25000=1.6*100=160%The above calculation shows he had attained an increase of 160% commission growth in one year, because his client list has been growing.

When that is the case, the likelihood is he will be getting more clients for the following year or at least he can retain a good portion of the existing client base, as long as he is in business. This will create three possible future scenarios where he might lose more or less than 10% of his commission if things start to go bad; he could earn the same amount of commission if the client list does not grow, or he could repeat the previous feat of 160% growth rate or even better.If he loses 10% commission, the outcome will be as follows:10/100*65000=650065000-6500=5850058500-42500=16000(Total expense + depreciation = 42500)If he loses 5% commission, the following will be the outcome.

5/100*65000=325065000-3250=6175061750-42500=19250If he accepts the offer at the investment company that pays him $40000 before tax and other deductions, by simply deducting the applicable expenses assuming that they will remain the same, at least for the first year considering that there is only one more year to go for the deprecation, the outcome will be the following. Applicable expensesCar expenses, gas, insurance 6500Depreciation 15000Assuming that the car expense remains the same at $6500 and the depreciation at $15000, there is $21500 to deduct as expense from the gross pay.

40000-21500=18500The $18500 is better than the $16000 he will get if his commission income had decreased by only 10% and as the percentage of loss increases, it will end up making the $40000 a better offer. However, if his commission remained the same he will make $22500 which is much better than he will be making at the investment company. Any increase on commission will continue to be a better source of pay than the $40,000 offer showing that the only time Charles will be worse off is if his commission income starts decreasing.

The even breaking point will be around 7 or 8% decrease in commission that will make the $40000 offer better, yet by not a very high margin showing that it is only as the percentage of commission loss goes higher the offer will become attractive.However, the reality is if the commission Charles earned had appreciated 160% for the current year, by using that as a probability, Charles’ gross income for the next year could be $104000 by assuming that the $65000 gross income had appreciated 160%.

When deducting his expenses assuming that the secretariat and car expense will remain in the same range, the net amount he will earn before tax will be as follows.104000-42500=61500Therefore, if he is optimistic about the increase of his client list, the $61500 he could generate at the end of the year will be much higher than what he will get from the investment company which will be $18500 creating a difference of $43000 showing that he has the opportunity to earn 232% more if he continues working for himself.

REFERENCEBodie, Z., Kane, A. and Marcus, A. J. Essentials of Investments, McGraw Hill Irwin, 2004Investoedia, Earnings before Interest & Tax (EBIT) Definition www.investopedia.com/terms/e/ebit.asp -Mills, John, Lynn Bible, and Richard Mason “Defining Free Cash Flow” The CPA Journal, 2002.Tarter, John, Federal Reserve Bank of Cleveland, Supervision & Regulation Department, “EBITA ad Useful Cash-Flow Too, But No Substitute for Good Judgement.Wallic, S. H. Difference Between Cash Flow and EBITDA - Yahoo! Voices .voices.yahoo.com/difference-between-cash-flow-ebitda-3337998.html