Hi,

So first I need to clear something up. When I posted on LinkedIn that I was working with 4G Partners, I really meant to post it as a project. You see, 4G Partners is a group of wireless industry consultants. I worked with the founders twenty years ago back in San Francisco, and we’ve been working on a project again (more on that below). But I see the power of LinkedIn! For those of you who thought I had finally taken a real job, it just ain’t true (sorry, Mom). I’m still doing The Brode Group thing. But thanks for all the congratulations & questions! Nice to know my buddies are out there.

Best regards,

David

(The following is a reprint of a newsletter from April, 2004.  I recently analyzed a company that had a solid P&L but didn’t hold up to scrutiny, and it reminded me of this theme.  I felt it was worth revisiting this topic. –DB)

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. It 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:

So far, so good. But look at the balance sheet

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:

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.