VOLUME 1
Chapter 2 - Fool's gold
"In 1542, encouraged by the exploits of Jacques Cartier, the flamboyant and opportunistic Jean-Francois de La Roque, Sieur de Roberval, sailed from France under the sponsorship of King Francois I, bound for a rendezvous with the famous explorer. He met the homeward-bound Cartier in Newfoundland and continued upstream on the St. Lawrence River to Cap-Rouge near present-day Quebec City. Here, along with a motley crew composed largely of French convicts, he established a fledgling colony which he named ‘France Roy’, on the river which he dubbed ‘France-Prime’.
Roberval’s forays upstream to the Lachine Rapids at Montreal and downstream to the land of the Saguenay were motivated more by tales of gold and diamonds than by geographical curiosity. But shipwrecks, winter cold, famine and disease quickly drove the would-be colonists back to France. After less than a year in Canada, de Roberval and his sickened, querulous crew sailed back to France on rescue ships provided by the King. Hopes for a new French kingdom faded, along with the value of de Roberval’s ‘precious stones’, found to be worthless quartz and iron pyrites."
Great Canadian Rivers 1
The loss on Roberval’s voyage is not hard to calculate. Before the ship departed there were stores to buy and a hire fee to agree with its owner. When the rescue ships hobbled back into port with their worthless cargo, what was left to pay was the crew's wages and compensation to the owner for the sunken ship.
Figure 2.1: The Lachine Rapids near Montreal
Henry Francis Ainslie, National Archives of Canada, C-506
http://canadianheritage.org/reproductions/23213.htm
In this special case, the overall loss was the same as the cash outflow. Whoever had backed Roberval was out of pocket by precisely the same amount as the calculated loss. Of course, sea voyages were often financed jointly by several individuals. A marine investment consortium was a sensible way to spread the risks associated with these early adventures. But in this case the loss per investor simply reflected his share in the consortium, and it was the same as the deficit in his cash. The loss for the year of Roberval’s voyage was the same as the cash outflow.
Let us now suppose that he stays away for several years, and let us also suppose that at the end of the first year, one of the investors wants to leave the consortium. What is his share of the consortium worth? We can no longer measure the cash flow, because all that we have is the initial expenditure: there is as yet no return. And we simply do not know whether there will be a return at all. In such circumstances all that we can do is guess. We can say "Well, Roberval is a seasoned explorer; last time he delivered the goods; there is every chance that he will return with a saleable cargo and that we will make a profit on the voyage. Our best guess of the final cash surplus is x and so we will pay the departing investor his share of x.”
There was another way to spread the risk of such investments, and that was to back more than one voyage at the same time. For every ship that disappeared at sea or limped back to port with nothing of value, there might be another that would return with glorious riches: with real rather than fool’s gold, or with exotic spices. A large syndicate might back multiple vessels at any one time, so that within the course of a single year there would be several embarkations, several ships returning from abroad and several reports of vessels and crew lost at sea. But this made the calculation of the syndicate’s profit even more complicated, because there was never a time when the day-to-day cash position reflected the underlying sense of a profit or loss.
Meanwhile the investors demanded a solution. Surely this problem simply required some ingenious mathematics of the type that Luca Pacioli had demonstrated himself so adept at delivering? Was there not some magic formula which could be applied to the cash inflows and outflows in such a way as to come up with a satisfactory and generally acceptable figure for the profit of the consortium in any given year?
It is worth pausing to think about this question, because it lies at the heart of a distinction between profit and cash flow that pervades the whole of accountancy. It is an essential distinction, because it enables us to allow for the fact that we do not live in a simple world. But it is also a massively misleading distinction, because the price that is often paid for the pursuit of profit is the abandonment of the clarity of cash.
Figure 2.2: A dream of future wealth
The conceptual framework that the mathematicians came up with is illustrated in Figure 2.2. We do not know whether Pacioli visualised the issue in this way at the time. Probably he did not, because the contents of the accounting section of his book are essentially tabular. But this simple diagram represents the essence of a distinction which has since become a fundamental part of financial measurement and management. It works like this.
Actual Cashflow is a pipe along which real money flows. If I tell you that my cashflow is 100 ducats, then what this means is that I now have an extra 100 of these coins in my pocket. They are eminently tangible: indeed each of them weighs about 3.5 grams of .986 pure gold. There are no assumptions or predictions associated with this statement: my cash flow is real, the coins are real and the only mistake that anybody could make here is if they failed to add them up correctly.
Estimated Profit however is something completely different. What flows along the Profit pipe is simply an assumption. It is a forecast of expected cash flows: a dream of future wealth. To return to the voyage of Roberval, Profit is simply the statement “Our best guess of the final cash surplus is x”. Only in special cases will profit and cash flow be identical, and this will be when the profit estimate was perfect and there is no asset left to consider. The ship is back in port; the ship owner and crewmen have been paid off; there is nothing of ours on the quayside and so the surplus cash in our pocket is the same as the profit on the voyage. But if we have another ship still at sea, or if we owe the crew their wages but have not yet paid them, or if our income from the sale of the cargo is an estimate rather than money actually paid to us in the market, then there is something left behind.
Assumed Asset is the name of that something left behind. If our forecasts of cash flow are perfect, then this asset will be the same as those future flows of cash. If Roberval’s ship is still at sea, but we somehow get word that he has real gold in his hold, we could then calculate the money to be made from selling it, subtract this from the cash we have already paid out and the wages due to the crew, and that would give us an exact forecast of the net cash surplus from the voyage. We could write out on the diagram above that the profit on the voyage was estimated at 100 ducats; we could therefore say that the voyage itself represents an asset worth 100 ducats; and in the fullness of time we expect to receive 100 ducats in cash once the ship has returned. Of course, once we have received those 100 ducats in cash, we will no longer have the original asset.
Figure 2.3: Saddam Hussein’s bathtub, Tikrit Palace
http://www.fresno6.com/images/iraq%20pictures/Saddam%20Bathtub%20(Large).jpg
How does arithmetic operate within this framework? Although the diagram is very simple, it is crucial that we understand it fundamentally. And the easiest mental model in this case is to think of bathwater. The profit pipe is an estimated inflow of water into the bath called Asset, while the Cashflow pipe is an actual outflow from it. The bath is initially empty. Then 100 gallons of water are estimated to flow into it through the Profit pipe. So the Asset bath is now believed to contain 100 gallons. At this point we open the outflow valve and if our estimate was correct, 100 gallons flow out of the bath along the pipe called Cashflow. Now the bath is empty again (Figure 2.3). Plumbers of a mathematical bent may like to summarise the arithmetic as follows:
Current bath level = Previous bath level + Inflow – Outflow
We can regroup this simple equation in various different ways, for example:
Current bath level - Previous bath level = Inflow – Outflow
which is equivalent to saying:
Increase in bath level = Inflow – Outflow
and that is precisely what we would expect by observing the water flowing into the bath. Alternatively we might choose to write the equation as follows:
Inflow = Outflow + Increase in bath level
Note that this last equation now defines an arithmetical relationship, not a causal relationship. In this rewritten equation we are not saying that the movement of water in the outflow pipe combined with an increase in the bath level will magically cause water to flow into the bath via the inflow pipe. All that is being said is that, if we do not know how much water has flowed in, but we know the amount of the outflow and the increase in bath level, then we can easily calculate what the inflow must have been. This distinction between what mathematicians would call an identity as opposed to a causal relationship is very important and we will return to it later.
Let us now consider the same equations for matters financial:
Current asset level = Previous asset level + Profit – Cashflow
So: Current asset level - Previous asset level = Profit – Cashflow
So: Increase in asset level = Profit – Cashflow
Therefore: Profit = Cashflow + Increase in asset level
Now as we saw above, Cashflow is real: it is the increase or decrease in our bank balance, and we can measure it exactly every second of the day. But ‘Increase in asset level’ is not a measurement: it involves a value judgement that may be right or wrong. However, once that judgement has been made, the figure for Profit is also established. In other words, if your equation is x = y + z, and you measure y, and you then make a judgment about z, the value for x is inexorably determined.
And it works the other way as well. If you measure y, and you announce a figure for x, then the figure for z is likewise determined. So we can restate this equation as follows:
Estimated Profit = Measured Cash Flow + Assumed Asset Increase
This equation is rarely, if ever, mentioned in accountancy texts, but it is probably the single most important financial relationship that we can ever learn. This is the equation that accounts for the sub-prime debt crisis of 2007; this is the equation that explains why Enron and Parmalat foundered: this is the equation that brought down Barings; this is the equation that expanded and finally pricked the South Sea Bubble; and this is the equation that explains why you can go bankrupt while making a profit.
Let’s take Parmalat as an example. On 23 Feb 2005 the UK financial journal Accountancy Age reported under the headline “Parmalat haemorrhaging £300m a year” that “The scandal-ridden Italian dairy group's chief financial officer, Fausto Tonno has revealed that the losses steadily accumulated over the past few years. Tonno, who is in jail, revealed that the firm lost between £235m and £303m from the mid 1990s to 2001. In total, the company lost almost £7.5bn over a 30-year period. To hide the losses Parmalat invented false accounts, including billions of euros it claimed was held in what turned out to be a fictitious Bank of America account in New York.”
So how does this very simple equation assist us in understanding what went wrong at Parmalat? The key is to start with reality, which is the cashflow. Parmalat’s cashflow from its business operations was very poor: in fact it was clearly negative for much of the period referred to above. That created problems for founder and former chairman Calisto Tanzi because he had to pay the farmers who supplied the company. So he and his family decided to borrow the money they needed from the banks. But because it is not easy to persuade a bank to lend money to a loss-making business, the Tanzi family hit on an ingenious solution: they would present the company as highly profitable instead.
On 8 Mar 2004 Accountancy Age reported “Bankrupt dairy group Parmalat made a pre-tax loss of £234m during the first nine months of 2003. The year before it had declared a pre-tax profit of just over £200m.” So the real outcome in 2003 was a loss of around £300m and we may presume that 2002 was not that dissimilar. In our equation:
Estimated Profit = Measured Cash Flow + Assumed Asset Increase
the actual outcome for 2002 was therefore something like:
£-300m = £-300m + £0
However, by the time the accounts were presented to the banks, they had been adjusted to present a result along the following lines instead:
£200m = £-300m + £500m
This required Parmalat to identify business assets that had increased their value by £500m over the year, which they did by inventing among other fantasies “a fictitious Bank of America account in New York”. Apparently this was less challenging a task than one might imagine: in a bulletin fondly anticipating the imminent demise of capitalism the World Socialist Web Site explained on 6 January 2004 how the devilish deed was done: “Parmalat’s finance director, Fausto Tonna, has told interrogators that he participated in a ‘cut and paste’ forgery, in which a document with Bank of America letterhead was scanned and then added to a document verifying a deposit account with that bank holding over $4.98 billion. The document was then passed through a fax machine several times in order to appear authentic.”
The principle was just the same for the 2007 sub-prime debt crisis. In this case the banks somehow imagined that they had an Assumed Asset Increase that was reflected in the mortgages they had offered to people who were patently unable to afford them and whose houses were of low value. Once it became clear that much of this asset increase was in fact worthless or even negative, the Estimated Profit rapidly turned into a massive Reported Loss.
So our equation Estimated Profit = Measured Cash Flow + Assumed Asset Increase is absolutely fundamental. But unless you are financially qualified (and perhaps even then), this is an equation that you don’t yet intuitively understand. You can see it theoretically, but it is not yet at the level of gut-feel. It does not live within your bones, this equation: it is not yet a matter of life and death. So we need to make it more real together. It is time to get strapped into the Business Flight Simulator.
1 http://www.greatcanadianrivers.com/rivers/stlawer/history-home.html
