VOLUME 2
Chapter 10 - Hubble, Bubble, Double-Entry Trouble
Readers may remember from “No accounting foretaste” (Chapter 8 of Volume 1) the cast of characters at Intergroup, the fictitious company that I invented in 1993 for the US magazine Chief Executive. These are Bob Trample (CEO), Jack Teflon (Sales), Elaine Foster (née Lissom, Marketing), Günter Kaputt (Production), Olaf Brainström (Planning), Kevin Rambite (Systems) and Harry Junkbond (Finance). That chapter was introduced by Bob saying to Olaf:
“Last month you told me you were about to solve all my corporate angst through a strange diagram labelled Everything You Always Wanted To Know About Accounting But Were Afraid To Ask Because You've Been Pretending You Understood It All At The Board Meetings For The Last Ten Years. I'm a captive audience; take me through it.”
A version of the following article appeared in Chief Executive magazine in the preceding month but I reproduce it (with some minor changes) here rather than earlier because I think it makes more sense to readers who have now become intuitively familiar with the reality of cash flow vs. profit.
You know from using the Simulator just how crucial it is to monitor your purchases, cash receipts and cash payments, so you may be justifiably concerned to realise that very few major companies succeed in bringing this information to the attention of their senior executives.
- Bob:
- Harry, I've asked you to give me some help today because I'm getting increasingly concerned about some of our Board financial schedules. You probably just regard it as Finance 101, but for me it's a real struggle to understand them, and I don't think I'm alone.
- Harry:
- What's the problem, Bob?
- Bob:
- Well I guess there are several problems. First of all, there are so many goddam numbers on each page that it’s a real effort to focus on them. It’s not as if I don’t start each meeting with the best of intentions, you know. I say to myself every time “This is the meeting where I’m really going to concentrate when Harry takes us through the results”, that sort of thing. And for the first five minutes it’s more or less OK, especially on the Profit and Loss Account page. I really think I’m beginning to get the hang of that one now. Look, you tell me if I’m on the right track. Here’s our P&L, right?
| Profit & Loss Account | $ million |
|---|---|
| Sales | 1500 |
| - cost of sales | -900 |
| = Gross Profit | 600 |
| - expenses | -400 |
| = Operating Profit | 200 |
- Harry:
- Yes Bob, that’s our P&L all right.
- Bob:
- So here’s the deal. We start with the Sales, that’s $1500 million for the year so far. And then you finance guys figure out what it cost us to make that stuff, that’s $900 million, which means that there’s $600 million left behind. But then there are some other costs, like my own compensation for example, and so after another $400 million of that we’re left with only $200 million of Operating Profit on the bottom line.
- Harry:
- Bob, that’s just great. This is all very encouraging. It looks like you’ve really cracked these schedules - in fact I don’t see why you’ve got any worries about them at all.
- Bob:
- Well let me try this on you. If we want to increase the profit, there’s two basic ways we can do it, right? We either increase the positives or we decrease the negatives.
- Harry:
- What do you mean exactly?
- Bob:
- Well Sales, that’s a positive, we could increase that, and we’d get more profit out that way. Or alternatively we could take Cost of Sales or Expenses, they’re the negatives, and we could decrease them and that would be another way to make more profit. So I don’t have a problem with this layout: it’s simple arithmetic and anyone can see that if you want the profit to increase, you either increase the sales or you reduce the costs.
- Harry:
- Like I said Bob, that is an awesome analysis, you really seem to have figured all this stuff out.
- Bob:
- Yeah, pretty neat eh?
- Harry:
- So what’s troubling you then?
- Bob:
- Well the other day I turned over a few more pages and I saw a schedule that looks to me to be very similar.
- Harry:
- You like this one? I think it's a gem. Here we go:
| Cash Flow Analysis | $ million |
|---|---|
| Operating Profit | 200 |
| + depreciation | +100 |
| - increase in working capital | -500 |
| - capital expenditure | -200 |
| = Operating Cash Flow | -400 |
- Bob:
- Exactly. So I looked at this new table and it seemed pretty clear to me too. Anyone can see that if you want to improve the cash flow, you have to increase the positive entries or else decrease the negative ones, just like on the P&L. So Harry, obviously all we’ve got to do to solve our cash flow problem is to increase the depreciation. If we could just get that depreciation up from $100m to about $600m, the cashflow will rocket up by the same amount and turn from $-400m to +$100m. It’s obvious from the layout of your table, so why haven’t we done that already?
- Harry:
- Bob, no I’m afraid that really won’t work at all. The depreciation is already included in our Operating Profit. We’re just adding it back here because it’s a non-cash item. So even if we were able to increase the amount, it wouldn’t make any difference at all to the cash flow.
- Bob:
- I don’t understand - say that again?
- Harry:
- Well, we already deducted that $100m of depreciation from our sales to calculate our Operating Profit, although admittedly the schedule doesn’t actually tell you that. So now we have to add it back again because it’s a non-cash item. Bob Because it’s a non-cash item... do I see what you mean? No, not remotely, but let me ask you another question anyway. Isn’t the Operating Profit a non-cash item also?
- Harry:
- Yes, that’s right.
- Bob:
- Well in that case, why don’t we add that one back too? Harry, are you OK? Hello? Is anybody there? Harry? Why are you foaming at the mouth and complaining about having to work with a bunch of financial illiterates? That’s a bit rich coming from you. After all, it’s your financial schedule in the first place, and I still can’t see what’s wrong with what I just asked you. If I’ve missed something in your analysis, surely you should lay out the information for us in a way that doesn’t contain all sorts of hidden traps? And while I’m about it, why is it called Cash Flow Analysis?
- Harry:
- Because it lets you figure out what your Cash Flow was by starting with your Operating Profit.
- Bob:
- Well I think I already understand cashflow. My cashflow at home is just the movement in my bank balance, so why are all these other figures there to confuse us?
- Harry:
- Bob, all that other information is there to help you.
- Bob:
- Oh really? Well here’s another problem. What I want to know is this. Since our profit figure is notoriously vague - you're always asking me what bottom line figure I want for the quarter, Harry - and since depreciation is also a function of our own choice of write-off rate, how can all these discretionary numbers add up to something concrete like our Net Cash Flow?
- Harry:
- Well, actually Harry, we don't really calculate it that way. We know the Net Cash Flow before we start - you’re right that it's just the change in our bank balances. So we put that figure in before any of the rest. Then we take off the capital expenditure, which we also know pretty accurately. Now you're right of course that the depreciation is a policy decision rather than a measurement, but whatever policy we have at the time, we put that figure in too. And that just leaves us with the profit and the change in working capital.
- Bob:
- Well, I'm no clearer. Surely we're going to come adrift here somewhere? How can we start from something vague - like the profit - and end up with something definite - like the cash flow?
- Harry:
- That's why they call me the Rubber Ruler! What number do you want for profit this quarter? All I have to do is to make the working capital change into the balancing figure, and we're laughing.
- Günter:
- But surely Harry, this working capital change means something important? Working is a good thing, so is Capitalism, so surely the more working capital we have, the better it is?
- Harry:
- No, no, you don't understand. Working capital is the sum of inventories and accounts receivable, less accounts payable. You want as little of those as possible. I make this schedule add up through a simple trick. We record the accounts receivable, and the inventory change is also tied in with the cost of sales and the profit, but the accounts payable is generally pretty vague. It gets bigger with purchases, and smaller with payments, but since our management accounts don't actually display either of these transactions, I can usually make it whatever I like.
- Elaine:
- Hold on Harry. You're telling me that your monthly statements don't actually tell us anything about our payments of cash to suppliers?
- Harry:
- Of course not, Elaine. Who'd want to do a wacky thing like that?
- Kevin:
- Well, I guess at least they register our receipts of cash from customers.
- Harry:
- Ugghh! Cash receipts? Not in my management accounts, if you please. Those details are kept way down in the cash-book. It's much too detailed for management.
- Bob:
- Hold on Harry. Let me see if I can understand this. You're telling me that our management accounts don't record our purchases, or our payments of cash, or our receipts of cash either. Am I going crazy or what? Aren't these things just fractionally important?
- Harry:
- Well, the accounting system itself does record these things, of course, otherwise the books wouldn't balance, but we don't show them in the monthly operating statements.
- Olaf:
- Are they in the quarterly or annual accounts then?
- Harry:
- Um, no, I guess we don't put them there either.
- Bob:
- Why not?
- Harry:
- Well, you need to bear in mind that the cash varies so much, I don't know that you could do a lot with it. Whereas our profit figures are smoothed through accruals, apportionments, allocations, activity-based costing and the duely diligent consultation of chicken entrails, which makes them much, much easier to read.
- Bob:
- Yes, but they just have the same old huge totals in them that hardly change every month. I like the idea of looking at something that varies. If we get confused, we could always put a rolling average through them, and it might even keep the Board awake.
- Harry:
- Bob, I can't advise you strongly enough to desist from this loose talk. You're suggesting a dangerous regression back to what we accountants scornfully call “cash accounting”. That may be good enough for balancing your check-book, but it lacks the sophistication we need at Intergroup.
- Bob:
- It may be loose talk, Harry, but just let me ask you this. What are the four largest recurring financial transactions for most companies?
- Harry:
- Um, I guess that would be sales, purchases, payments and receipts.
- Bob:
- And of these, you accountants show us managers... just the sales?
- Harry:
- Look, Bob, I can explain everything. Think of double entry. Think of Father Luca Pacioli. Think of debits and credits, balance sheets balancing, overhead absorption, overhead cam-shafts, the music of the spheres, contrapuntal atonal harmonies and while you're about it, don't forget the executive profit share scheme. So don't worry about the details, Bob; you can leave them all to me.
- Olaf:
- Look guys! Out of this cauldron of camouflage is emerging a strange picture of piercing clarity? What can this mean? What is this strange diagram I see before me, labelled Everything You Always Wanted To Know About Accounting But Were Afraid To Ask Because You've Been Pretending You Understood It All At The Board Meetings For The Last Ten Years?
(to be continued...)
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