Flawless Financials the Financial Forecasting Online Newsletter from Minotaur Financial and David Brode April, 2004 Sent monthly to over 400 subscribers. Please pass on Flawless Financials to those in your network. To leave Flawless Financials, follow instructions at bottom. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * This month: Income vs. Cash Flow Statements * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * It's the Cash Flow, Stupid! Everyone knows that Cash is King. So why do we focus so much attention on the Income Statement? You know what I mean about focus: when people ask if the books are closed, they aren't huddled around the printer checking the Shareholders' Equity line. No, companies release quarterly earnings reports. Managers talk about having P&L responsibility. Isn't this odd? In this newsletter I want to a) explore the history of this area, b) sing the praises of the Cash Flow Statement, and c) circle back to why we focus on the Income Statement. History I always thought the progression was Income Statement to Balance Sheet to Cash Flow Statement because that's how I learned to model. It turns out that isn't how financial statements developed. Historically, the Income Statement is the "middle" of the three financial statements. The Balance Sheet is truly ancient. Egyptian papyrus and Sumerian clay tablets--some of the oldest written records--are lists of assets. Its wasn't too great a leap for people to start recording liabilities along with assets, and the Balance Sheet was born. As business ownership became distributed, shareholders needed to know the change in value over a period of time. When debt capital markets developed, lenders wanted to see that the company could make interest and principal payments. These two factors--focused on profitability--led to the adoption of the Income Statement. Over time, shareholders and lenders found that you could hide a lot of sins in the Income Statement and Balance Sheet. At the turn of the 20th century, there were multiple versions of Cash Flow Statements being used: for working capital, for cash, for current assets, etc. Only in the last generation have we standardized on a Cash Flow Statement that combines all of these functions. The trend here is towards greater explanation. It gets harder to hide from reality when you add an Income Statement and then a Cash Flow Statement. Cash Flow Statements "You can have a bag full of profits or a bag full of cash. Which is it gonna be? I don't know about you, but I'll take the bag full of cash!" Why is this? Aren't profits good? Sure...but profits don't guarantee an increasing cash balance. Look at Enron or Worldcom, two great examples of this principle. Or even consider this simple case, which doesn't involve shady dealings: Feb. Revenue: $100 Cost of Goods: 40 Gross Profit: 60 Operating Expenses: 25 EBIT: 35 So far, so good. But look at the balance sheet Jan. Feb. Cash 100 75 AR 40 100 Assets 140 175 Equity Capital 60 60 Retained 80 115 Tot. Eq. 140 175 Cash went down by $25. Why? Profits were $35, but with a $60 increase in payments due from customers, cash fell $25. Where does the truth come out? In the Cash Flow Statement: Operating Cash Flows Net Income 35 Change in Working Capital (60) Total (25) Investing Cash Flows 0 Financing Cash Flows 0 Change in Cash (25) Starting Cash 100 Ending Cash 75 So Why Do We Focus on the Income Statement? 1. Novelty. The Cash Flow Statement is still somewhat new. It has only been a required financial statement in its current form since 1988. 2. Taxes. Congress passed the 16th Amendment to the U.S. Constitution in 1913, authorizing Congress to impose a tax on income. It ain't a cash flow tax: it's an income tax, and that is derived from the Income Statement 3. Critical Link. The Income Statement is the critical link in the financials. If your income statement is strong, then everything is going to work out. Just as the revenue line is often the key to the Income Statement, the Net Income number off the income Statement is often the key to a strong Cash Flow Statement. If Net Income is strong, everything else will fall into place. 4. Satisfies Everyone. For a high-level review, the Income Statement can answer questions from shareholders, lenders, and the government. So even though the Cash Flow Statement contains definitive answers, often you can get 80% of the answer in 20% of the time by focusing on the Income Statement. Until next month, all the best, David Brode -- Minotaur Financial Removing Financial Issues as a Deal Roadblock * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * NEWSLETTER ARCHIVE AVAILABLE Make sure to visit the Minotaur Financial website for the Newsletter Archive at http://www.brode.net/resources/ * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * http://www.brode.net mailto:David@Brode.net 1919 14th Street, Suite 510 Boulder, CO 80302 (303) 444-3300 * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * ABOUT DAVID BRODE I’m a financial modeling specialist. Over the last fifteen years I’ve completed dozens of models and certainly thousands of versions to support corporate development, M&A, strategic planning, and debt and equity transactions. These models have raised over $1B in debt and $100M in venture capital and private equity. Over time I’ve consistently revised software tools and work processes to get the job done quickly and well. If you have a financial forecasting issue, I’d love to help. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * (c) 2004 Minotaur Financial, All rights reserved. You are free to use material from the Flawless Financials newsletter in whole or in part, as long as you include complete attribution, including a live web site link. Please also notify me where the material will appear. The attribution should read: "By David Brode of Minotaur Financial. More articles on financial forecasting can be found at http://www.brode.net " * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * Are you struggling to convince others to do a deal which you think is a no-brainer? To discuss how you can take numbers off the table as a deal roadblock, call (303) 444-3300. I'm very accessible and glad to help. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * DO YOU LIKE THIS NEWSLETTER? You are welcome to share this email with colleagues who would benefit from better numbers. Your feedback is always welcome and appreciated. Write in to mailto:feedback@brode.net. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * PRIVACY POLICY: I never rent, trade, or sell my email list to anyone for any reason whatsoever. You'll never get an unsolicited email from a stranger as a result of joining this list. To SUBSCRIBE FREE to this newsletter, send an email to mailto:subscribe@brode.net. And you'll get Minotaur's Financial Forecasting White Paper in the deal. To be REMOVED from this list, send an email to mailto:remove@brode.net. (Please note that this message needs to come from the email address that originally subscribed. If you need help determining this, please email mailto:David@Brode.net.)