A few days ago I received the following question from a reader. I consider this a good "Intermediate Accounting" question for Rule #1 investors to look over. The basic question: does a growing equity number really mean the company is growing surplus cash?
Greeting from Shanghai! Thanks for your book which inspires me a lot!
I am now reading your RULE #1 book the 2nd time. I am now on Ch9 'Calculate the Sticker Price'. In the highlighted box on P151, you said 'The growth of the Sticker Price - the value of the business - most closely follows the growth of equity because a growing equity comes from growing surplus cash'.
I am confused. In my view, increase in equity does not imply increase in surplus cash at all. For example, a company sold only 1 item of USD10m in a fiscal year and made a profit of USD4m. Its revenue is USD10m and profit is USD4m. But its customer failed to pay. At the year end, the AR increased by USD4m but not the cash. However, the retained earning still increased by USD4m, and thus the equity increased by USD4m as well.
Please help me to understand. Thanks in advance.
Here is my response to David:
I'm glad you are enjoying the book in Shanghai. I'd love to find an excuse to come visit. Especially since your question goes deep.
You are right that Account Receivables will increase Equity. Very true. However, AR that are collectible are almost cash, right? In your example, the AR isn't collected on time at all, but is still retained on the books as a viable asset.
If it isn't collectible then the CFO isn't going to keep it as an asset, right? If he did, he'd be kinda lying and that's not the sort of business people we want to invest with.
Good AR is just like cash if the CFO is doing his job. So, while you are correct, I like to keep the accounting jargon to a minimum and just get to the heart of the issue.
Congratulations on a great Olympics and best wishes for 2009!
Now go play,