Where did our cash come from (or where did it go)
Today's main topic is "Cash Flow Statements". A Cash Flow Statement is a document
which analyses the movements of cash in and out of the firm, over an accounting
period, and therefore explains the change in the Cash & Bank account balance. It
is the same thing as a document called "Analysis of Sources and Uses of
funds". There are many presentations; we shall study one of them today. We already
saw that a sale on credit doesn't bring right away cash into the firm, so the
movements of cash are a bit more complicated than just the movements of
The idea is to explain the evolution of the cash (+bank) account, in the balance sheet, from one year to the next, in terms of the usual accounting concepts we are familiar with:
Importance of CF statements
CF statements are important to control cash. And to forecast cash in the firm.
Cash and financial securities
Modern cash, as we know it, has a long and interesting history. Until the advent of central banks with a monopoly to issue legal tender bank notes - in the middle of the XIXth century in most developed countries - the bank notes, which are today's "cash", were only financial securities issued by banks. Financial securities (we shall have ample opportunity to study them) are pieces of paper, or electronic equivalent, which promise the bearer to receive from the issuer some money in the future, according to a specified schedule (the terms of the contract which the security actually is). As such a financial security has a value when it is issued, and it is precisely the amount of money the investor (= buyer of the security) gives to the borrower (= issuer of the security). The transformation of certain types of financial securities issued by banks into "legal tender" bank notes, parallels the development of modern nation-states over the last thousand years.
From feudality to absolute monarchies and to modern nation-states
When incipient nation-states, in Western Europe, emerged from feudality between the years 1000 and 1200 (France, England, Spain, and various smaller states forming the Holy Roman Empire), they were not concerned with their "monetary and financial system"; they were just big borrowers (for crusades, wars and other similar expenditures), and they also tampered with money: they would stamp a certain value on coins that did not contain the quantity of precious metal the stamp was supposed to mean. But, being unaware of its importance, they let the banking and financial system develop spontaneously. Only in the XVIIth and XVIIIth centuries was it clearly understood that to control the money as well as the banking and financial system of a country ought to be a prerogative of the state authorities, that is the monarch. Following the American and French revolutions of the preceding century, in the XIXth century absolute monarchies gave place one after the other to more democratic regimes, but the idea that the state must be in control of its money, and banking and financial system remained.
Fundamental event of the last 30 years
The fantastic development of financial markets: a feature of the 80's and 90's; the result of the Thatcher/Reagan liberal revolution. The 3D's:
- disintermediation (encouraging firms to find their financing directly from the markets, rather than from banks)
- dismantling of barriers between the two types of banking: retail banking, investment banking
It is quite likely that, as a consequence of the present worldwide crisis (2008), the western world will back track on the 3D's: at least enforce more regulations, and set up again more barriers But there was another cause to the tremendous development of finance since 1980: computers and the Internet! And these are here to stay.
A likely future
To make a long story short, we, at the beginning of the XXIst century, are witnessing the slow demise of nation-states, following the diminishing control over their money. It is likely that the next generation will see the appearance of new private moneys freed from any ties with states. This may happen smoothly, or not. For the time being, all western governments are gearing up the fight against the crisis with remedies which will create a big and durable inflation.
Double-entry accounting is value accounting, but we are still
interested in cash
Remember that the income statement and the balance sheet of a firm record
movements and final states of values. Some of it is cash, but most of it
is not. A firm makes a profit when the difference between its total assets and
the total liabilities to external agents increases. If a firm buys a new
piece of machinery on credit, its total assets increase, but its total
liabilities to external agents increase by the same amount, so there is no
profit. If it pays with cash, the total assets and liabilities don't change. But
if a firm sells for 100 € an item recorded in its stocks for 40 €, then the
total assets increase by 60 € (the stocks decrease by 40, and the cash or the
debtors increase by 100) and the liabilities to external agents don't change,
therefore it is the net worth that changes, and this change is the profit of the
operation. A firm can make a profit without any cash involved; for instance, a
profitable sale on credit.
Cash is the ultimate measurement of wealth, and of
However, cash plays a central role in commerce and in economics: it is the
ultimate measurement of wealth. It is the only accepted way to pay, either right
away or with a little delay called trade credit. So a firm must have cash to pay
its bills and its debts; it is not enough that it have value. So it must generate cash; and it generates cash via exchange.
Cash is a "proof"of worthiness
That's the magic of cash: it proves that somebody else indeed attributes to
your product the value you think.
Delay between movements of value and movements of cash
Since there are delays between entry of value and entry of cash in a firm,
due to trade credit, and since we must always know how much cash we have and we
will have in the short term future, an analysis is required to explain and
monitor the evolution of the cash account. This is the role of the Cash Flow
Money in the till is no indicator of profit
The money in the cash & bank account, at the end of the year, has little to do
with the profit made by the firm over the year. There are many sources of cash
with no relation with profit (bank borrowing, debtors who pay, disposal of
assets, etc.), and there are many uses of cash with no relation with profit
either (investments paid cash, loan refunding, creditors we pay, etc.). The
value of a firm has a very indirect link with recent cash generation
- and on top of that, it depends upon the value it can create in the buyer's
Skype = future extra cash for eBay
The example of Skype is striking. It was created two years ago; it has
generated no profit, and no cash whatsoever; and, yet, it was valued at $2,6
billion by eBay. How come eBay thinks that Skype is worth so much? The answer
lies in the future. The future extra cash flows for eBay may be huge, and they
have a value today, properly discounted to take into account their uncertainty.
Think of Skype as a key (made of plain iron) which will enable you to open a
trunks containing a treasure. The value of the key is definitely not just the
cost to make it! And we see that the "value of the key" depends
upon the trunks that the buyer has and wants to open. In other words, the same
firm (or even object) has different values for different potential buyers.
eBay, in reality, bought time
Analysts think that eBay might have paid too much. After all, there were
alternative options: with $2,6 billion, you can certainly develop Skype
technology yourself. Here, the crux of the matter is time: even with huge
amounts of money you may not be able to reproduce Skype technology in less than,
say, two or three years. So eBay purchased the head start, and prevented other
competitors (Google, Microsoft, Yahoo, and others) from acquiring Skype
technology right away.
Producing profit whilst going bust
Back to cash: there are two basic ways to be profitable for several years,
and yet run into a severe cash shortage. One of them has to do with the clients: you may turn plenty of profitable sales, but on credit, and have your client
account inflate beyond what is reasonable. And an inflated client account usually
includes bad clients who will never pay. Another typical way is to
expenditures that, in truth, should be counted as consumption of the year, for
instance R&D expenditures, or investments in the Selling&Distribution network,
or Advertising. All these expenditures can be treated as investments, because
they concern many years, yet they must be paid with cash within a few weeks of
their purchase. Too many capitalized expenditures may hide problems and losses.
When we are overly optimistic in the treatment of our accounts, we violate one
accounting rule: the prudence rule.
Cash is a measure of trust the rest of wold has in our
The cash that a firm has, or may get very quickly, is a measurement of the
trust that the outside world has in it. It is the trust that the firm is able to
create value, and value that can be sold, i.e. value that other people will be
willing to exchange for cash. Once again, this is the magic of cash: it has no
intrinsic use (you don't take it with you on a desert island), it is, at any
point in time, a measure of the trust other people have in you.
Movements in the cash (and bank) account
Basically, a cash flow statement is a way to present all the cash the flowed
into the cash (& bank) account, i.e. in the debit column, and all the cash the
flowed out of the cash (& bank) account, i.e. in the credit column, over a given
period of time, usually the accounting period.
Yesterday, we studied the BS and IS of a firm over two years. Let's go into
more details and analyse the evolution of the cash account in the BS.
From the end of 2002, to the end of 2003, the accounts were these (units K€):
An illustration of profit with no extra cash
We see that the cash account balance did not move, it staid at 50 K€. Yet,
the firm made a profit of 47, of which it distributed 27; it sold for 800 K€ of
goods, it purchased things, it raised money via bonds, etc. Some of these
movements corresponded to movements of cash. We shall see what was the cash
inflow and what was the cash outflow (also called cash outlay).
The following year, in 2004, the accounts were these:
Profit: 60. Cash balance change: 50 -> 80. Sales: 1000. Investment in
short term securities: 50. Etc.
Let's analyse, first, the movements over the year 2004.
Cash inflow in 2004
Causes of cash inflow
During the year, from the 1st of January until the 31st of December, in which
instances does cash flow into the firm? What are the possible causes ?
Cash sales and past sales turned into cash
First of all, sales for cash obviously produce a cash inflow. But we are not
told what were the sales for cash. We only know that the total sales were 1000
K€. We should deduct the sales on credit and not yet paid at the end of the
year. Conversely, debtors at the end of 2003, who paid in 2004, also provided
Cash from sales = Sales - Variation in Debtors
So we have Cash from sales (of the year or of past years) = Sales - Increase
in the debtor account = 1000 - (270 - 200) = 930
Other sources: borrowings
There are other possible sources of cash. For instance, an increase in
borrowings. Here, the bond and bank borrowings did not change. So: no cash
inflow from borrowings.
Other sources: divestments
There may also be disposal of assets for cash. For the sake of simplicity in
the calculations, we shall make the assumption that the firm did not sell any
asset during the year. (If it did, the calculations would not change in their
principle, but they would be a bit more messy.)
There may be a liquidation of some of the short term securities. But here
they increased, so we shall rather count them in the cash outflow.
That's all for the cash inflow: 930 K€.
Cash outflow in 2004
Causes of cash outlays
Same basic question: what are the possible causes of cash outflow during the
year? Obviously payments in cash, either for cash purchases, or cash payment of
past creditors, and also various other cash payment (cash operating
expenditures, financial charges, increase in ST securities, etc.)
Cash paid for purchases (present or past)
Let's start with the Purchases. They are paid in cash except for the increase
in Trade creditors (assume the suppliers account represents the trade creditors).
Then, we have
Cash for purchases = Purchases - Variation in Trade
cash outlay from purchases = purchases - increase in trade creditors = 500 -
(100 - 80) = 480
Cash operating expenditures
Secondly, the cash operating expenditures are paid in cash: the salaries,
the rent, etc. = 250 (we could refine the example to have a more realistic
analysis, but it would add nothing to the explanations).
Non cash expenditures. In a standard cash flow
statement presentation, depreciation does not appear
Note that the yearly depreciation is not a cash outlay. It is only an
accounting entry to justify the decrease in the value of the fixed assets. The
cash actually flowed out long ago. And, indeed, there is no entry either debit or credit in the cash account or the bank account.
(There are other presentations of the "Sources and Uses of Funds" where the
yearly depreciation is included in the sources of funds (akin to the cash
inflow), added to the net profit... It is another kind of presentation, which we
will not study. Life is tough enough like that:-) )
Other non-operating cash expenditures
Then we have the financial charges and the taxes and the dividends = 60. If
some of them were not paid in cash, it is corrected by the next item: increase
in other creditors, which should be subtracted: Minus increase in other
creditors = - 40
Investments paid cash
Finally, there are the investments of the year (either in gross FA: 100, or
in ST securities: 50) = 150.
Now, we have recorded all the cash outlays. The sum of all these numbers is
500 - 20 + 250 + 60 - 40 + 150 = 900 K€
In other words, the cash inflow was 930 and the cash outflow was 900. So the
cash account must have increased by 30 K€.
It is summarised in this document
Exercise: do the same analysis for the year 2003.
You should get this:
Make sure that you can explain each line.
Difference between a Cash Flow Statement and an Income Statement
A cash flow statement is not an income statement
It is quite important to understand the difference between a Cash Flow
Statement and an Income Statement. Both are fundamental documents for the
firm. General accounting computes first the Income Statement, together with the
Balance Sheet, and then establishes the Cash Flow Statement.
The income statement keeps track of value coming in
from and consumed for operations
General accounting is concerned with keeping track of value, and
when this value is created or consumed. The income statement records value
entering the firm and value leaving the firm during the accounting period (and
only value participating in the operations; a new bank loan producing 100 K€ of
cash is not recorded in the Income statement, nor is the acquisition of a van,
however we paid for it). It applies the Matching rule.
The cash flow statement is only concerned with cash,
wherever it comes from or goes
The Cash Flow Statement is concerned with the movements of cash
(whatever their cause), and
what explains the changes in the cash account balance. Cash movements at date t
usually don't match with consumption, or sale, at date t. Remember that the cash
is the "blood" of the firm; a better image, perhaps, is that it is the measure
of the trust other people have in the firm. It is the ultimate account necessary
to make payments, so it must be monitored. An old boss of mine, Alan Zekon,
former head of BCG, used to say that the only relevant accounting method is the
"cigar box accounting", the accounting method that worries only about the cash
in the box where we keep money. He kept his money in a cigar box. (He liked
cigars very much, too much.) Of course it was a joke, but it conveys a lesson:
what, ultimately, makes a firm capable of paying its debts is cash, and what,
ultimately, makes a firm rich is how much cash flowed into its till.
Case of a new bank loan
A new loan from a bank, producing 100 k€, will not appear in the Income
Statement, but it will appear in the Cash Flow Statement.
Why look at the income statement
So why do we pay any attention to the Income Statement? Answer: because it
measures the profit creation. But profit is not cash. It measures the increase
in the value of the assets in the firm, created by its operations, and not just
by more liabilities to outside agents.
Why look at cash
So why do we pay any attention to the Cash Flow Statement? Answer: because
a firm goes bankrupt when it runs out of cash (not out of value). So we must be
able to explain, and to forecast, the movements of cash in the firm.
Various approaches to valueing a firm
There are various approaches to figuring out what is the value of a firm you
there is only one correct answer: it is the highest price someone is willing to pay
acquire it. It is the value for that buyer, and you job is to
sell him your firm at a price as close as possible to this value, even if for you
the firm is less valuable.
- The total assets.
- The total assets net of the debts (i.e. the Equity), if they are to take
charge of the liabilities too.
- Some valorization of the stream of future cash flows (i.e. dividends).
- Considerations taking into account the buyer and its operations:
the stream of extra cash flows for a potential buyer
Financial investment: a financial investment is an investment with no
interference with our other activities, or that we don't intend to run.
Otherwise it is called a physical investment.
Case of a financial investment
For a financial investment, the correct approach is number 3.
Modern Financial Theory reaches this paradoxical (but somewhat moral) result: in a perfectly
functioning market, it is not possible to make money with
financial investments (they are always offered at a price that is equal to their
value, be they stocks, bonds, options or any of the more exotic securities that
we can now purchase in financial markets). This fact is so annoying that, in
standard financial textbooks, it is usually only mentioned in small print after
a few hundred pages of learned calculations.
Case of a physical investment
It is only possible to make money with physical investments. In that case
only approach number 4 is correct.
Why Warren Buffett became so rich being only a financial investor? Because,
as he has been pounding for 50 years - and, before him, his
Graham - stock markets are everything but well functioning; they are more like
beheaded chicken, and sometimes they offer opportunities to make money, either
as a buyer or as a seller. But Buffett also say, very politely, that MFT, if
comprising interesting mathematics, is just financial baloney. Cf his famous
speech at Columbia University in 1984 entitled "Graham and Doddsville".
Let's turn to a fantastic, yet real, illustration of this distinction between
financial and physical investments.
More on Skype and eBay
Considering that Skype was created in 2002, reached
sales of the
order of $7 million, and made only losses, how
can we put a price tag on the firm? And how eBay (which purchased it in 2005)
came with a value of $2,6 billion?
A striking example of financial reasoning
Note that this example is extraordinary, but it is real,
it happened in October 2005, and it is
a good illustration of a financial reasoning. And a similar example involving Google and YouTube
happened in October 2006, when Google paid $1,7 billion for
The past of Skype, as well as the future of Skype as a
standalone, are irrelevant
To eBay, what is interesting is neither the past of Skype, which is of no concern (except
for the promises it holds), nor the future of Skype as as
standalone. What interests eBay is the future of eBay, with Skype owned by eBay,
rather than owned by a competitor.
Key to a treasure trunks
Think again of the price you are
willing to pay for the key to the treasure trunks: you don't care how much it
cost to make the key! Even though to make a key costs $2, if the key,
interests you and someone else possesses, can open for you a treasure trunks full
of wealth, this $2 price tag is irrelevant. You'll be willing to pay a figure
that is in relation with the wealth in the treasure trunks.
Series of estimated future extra cash flows
In theory, eBay computed its future cash flows with Skype, and its future
cash flows without Skype. Suppose the series of differences is this (now I make
up numbers, in millions of dollars):
Akin to a budget exercise
Of course, they need a good accounting system, general accounting and cost
accounting, as well as a good wet finger, to come up with this. You need
forecasting techniques, some are concerned with markets, and market shares, and
sales, some are concerned with your own future operations ; they are not called
forecasts in that case, but plans. You forecast the weather for tomorrow,
but you plan to do this, or that, depending upon the actual weather
Obviously, if purchasing Skype will provide these extra cash flows, it is
worth looking whether Skype can be purchased. And at what price?
The sum of these cash flows is $9,5 billion. But that's certainly not what
eBay should pay for Skype. Nobody (except lottery players) will pay today $9,5
billion to get back, over the next 7 years, the same sum with a high risk that
it be less (or more).
But it no longer appears stupid to pay $2,6 billion to secure the possibility
to get these future extra cash flows.
The technique of discount: more about it later
In fact, finance has a toolbox of techniques to try and put a value today on
this stream of cash flows. (For those of you who like to look into the future of
this course, you will discover that this stream of CF "discounted at 40%" yields
a value today of $2,6 billion.)
But before we go into financial calculations, there are other topics that we
must review or cover first, among them cost accounting, and then simple probability
Sources of money to finance an investment
The three standard ways are:
- new shares,
- new bonds,
- new bank borrowings.
Paying a purchase, in part with new shares of stock
Of course, you may also already have the money in your assets, from past
retained earnings (it can be analyzed more precisely in another cash flow statement
presentation than the one we studied). It is called auto-financing. Or, perhaps,
you had other sources in the past, the proceeds of which you haven't used yet.
eBay paid half of Skype with cash it already had, and the other half with new
shares directly given to Skype owners. Microsoft is awash with cash from past
profits (check on Yahoo finance how much). Google is cash awash from last year
IPO (initial public offering of new shares in the stock market).
Liquidating some assets to get cash
There are still other ways. Firms encountering cash difficulties, and which,
for one reason or another, can no longer borrow, will try and liquidate a part
of their stocks, or they may sell unnecessary assets. They may also sell assets
which have huge excess real value over their balance sheet value, and make
replacement investments elsewhere (if the replacement cost is much less than the
selling value). This is the situation of Michelin, which has four plants inside
Go to part 2