Friday, November 25, 2011

The Cash Flow Statement: An Examination

     The example above is a basic cash flow statement. All businesses have one. It reveals the bottom line. In essence, what works...and what does not (as a side note, a state, nation, and individual has a cash flow statement and balance sheet that follows them wherever they go...whether they realize it or not). So let's take a close look at what the businessman uses as a tool to guide his decisions, shall we?
  1. The sales. This is money coming in from the selling of the product or service that the business offers. This is where the individual (read consumer) has the most power. If he or she does not buy the product, the company goes out of business. In a free market, this company has to woo the customer to buy...and keep buying. The organization has to keep improving it's product or service to stay in business. Many factors come into play. A competitive price, quality, better service, a specialty serving a niche, etc... They all play a role in better sales.
  2. Expenses. As you can see, there is a laundry list of expenses. The common term is "the cost of doing business". Expenses add up. A little here, a little there. The next thing you know, there is not much left. I'll break these down a little later.
  3. The profit...the bottom line. This is what is left after income minus expenses. This example shows a profit of 5% for the month, and a profit of 10% for the year. The profit is what goes to the owner(s) of the business as dividends. 
     For starters, a business has to run at a profit. If it does not, it has to close the doors. This is so important, I'll say it again. A business has to run at a profit. If it does not, it goes out of business. If it has a cash reserve or a line of credit, it can run in the negative for a while. But it cannot do that forever. Sooner or later, it has to run at a profit. Most businesses in most industries run between 5% to 10% profit over a long period of time. In other words, for every dollar a business brings in, 10 cents is what the owner(s) keep. So let's play with the balance sheet above to see what a business owner has to do faced with certain situations.
     Let us start with payroll. This cash flow statement shows wages paid out for $10,000 of sales at $2,500.00. Along with that, the business had to pay payroll taxes of $600.00. This makes it a grand total of $3,100.00 for the business owner to pay for labor on $10,000.00 of business. Let us assume that the owner has 2 employees working for him. The numbers will break down as follows:
  • Monthly take home pay  $1,250.00 per employee.
  • Taxes.
    • Social Security taxes paid by employee: $87.50.
    • Social Security taxes paid by employee on behalf of employee: $87.50.
    • Other employee taxes: $112.50.
     I want to point something out here. The total taxes paid per employee is $462.50. This total comes from the sales brought in by the company. It does not come from the profits of the business. Remember, it is part of the expenses of doing business. So in this case, taxes taken out from the business could have gone somewhere else if, say, he did not have to pay Social Security taxes. He could have (and most likely would have) paid his employees more in wages for the labor performed. If you add in the 15% total the employer had to pay SS to bottom line wages, the business owner could pay his employee an extra $350.00 a month. Let me ask you, would you make better decisions with what you would do with your money than the government with the S.S. mess we have today? Would it be easier for you to save for your own retirement than what S.S. is doing with your "retirement?
     Let's take the tax situation further. Progressives call for more taxes on corporations. They think businesses are "too greedy", so they need to pay. Well, let's look at the cash flow statement again. This particular example does not show the business paying corporate taxes, but they do. Right now, the corporate tax rate in the United States is 35% (by the way, that is the second highest corporate tax rate in the world. Japan is the first). To veer off course a little bit, I need to clarify between a sub S corporation and a C corporation. A sub S corporation is usually used for a small business in that both the personal and business taxes run straight through to the bottom line. A C corp is set up to where you have share holders, and because of the arrangement (a C corp is usually formed for a big business), the corporation pays it's taxes, and then the shareholders get taxed on dividends. In essence, the owners get taxed twice. Now let's take a look at what happens to the cash flow statement. After all the expenses it takes to run a business, the company now has to pay 35% from the profits. In this case, the bottom line profit is $500.00, so 35% of that is $175.00. This leaves a total profit of $325.00. In this example, after all expenses are paid...and taxes...and working to bring in sales (and most likely the owner working long hours), he gets to keep $325.00. Tell me, how motivating is that?
     Now let's examine minimum wage requirements on the cash flow statement. Once again, progressives make a strong case that a business must pay a "living wage", whatever that is (mostly determined by bureaucrats that have no business sense). In this example, the 2 employees are earning $12.91 an hour (assuming they work a 30 hour week). Admittedly, this is a reasonable wage, but let us say that the powers that be decide that each worker now must be paid $15.00 an hour. What would happen? This:
  • Total wages paid would be $3,600.00.
  • Total Social Security paid would be $540.00. 7.5% from the employee, 7.5% from the employer.
  • Total taxes now paid would be $765.00.
     With the new, higher wages added to the expenses, the total expenses now paid is $10,000 for the month. Since the increased wages did nothing to improve the bottom line (in essence, the workers get paid more for the same amount of production), the owner now makes no profit at all. He breaks even for the month. Suppose that the following month he only sells $9,500.00 worth of goods. He will lose money, but because of the new law he still has to pay his employees the same wage. It becomes very evident that this cannot continue. What are the choices for the business owner? He can fire a worker and try to get by with less help. He can try to increase sales, but that would come with extra costs associated with it. He can try to raise prices on his product. That's about it. If he raises prices too high, consumers will go somewhere else or stop buying the product altogether (or cut back on the amount he or she buys). If he cannot make the necessary adjustments and run again at a profit, he will close up shop. After all, nobody wants to work for free, and just as importantly, investors do not want to lose money or take big risks to break even.     
      Next let us examine the effects of government regulations on the cash flow statement. We'll use just one example. Let's say the EPA (Environmental Protection Agency) determines that to produce the widget this company sells causes a lot of pollution. The cash flow statement above shows purchases made, meaning this organization sells the final product. It does not make it. The EPA then imposes strong pollution requirements on the company that produces the widgets that it has to meet. By doing so, the cost to produce the widget goes up from 20 cents to 50 cents. Here is what would happen. Since this particular company buys the finished product to sell at the retail level, the outcome will be as follows:
  • Before the price increase the company can buy 15,000 widgets for $3,000.00
  • After the price increase, the company must pay $7,500.00 for 15,000 widgets.

     Back to the cash flow statement. If it now costs $7,500.00 (up from $3,000.00) for the same amount of widgets and the total income sales is still $10,000, then the company will run at a loss of $2,500.00.
As noted above, how long can a company run at a loss? Who would want to invest in a company that runs at a loss? The only thing the company can do (and hope to still  have customers), is to raise the price. It is passed onto the consumers. 
     These are just a few examples. A real business has to deal with much more, such as workman's comp, unemployment insurance, occupational "privilege" tax, and so on. Every time the government adds more regulations, taxes, and any other such demands, it makes it more difficult for the enterprise to keep going. If these restrictions get too strong, the business cannot continue. That means jobs are lost. That means there are less products or services offered. It means a lower standard of living for everybody. Personally, I believe that this is the main reason the United States is losing it's manufacturing base. The labor unions, although they did much good initially, pushed for too many benefits for the employees. The United States government in an effort to improve working conditions and lower pollution output went too far. Both of these actions over time has changed the employment landscape in the United States. I am also afraid that it would be difficult to reverse it. It would take concessions in wages and benefits, along with a roll back on regulations to bring it about. In short, people are going to have to be willing to roll up their sleeves, accept that they will have to be paid lower wages for work performed, work hard and save more than they spend to rebuild our nation's capital base. Our manufacturing base can then be rebuilt and we can finally see an improvement in wages and our quality of life. This will take time. A lot of time.

Wednesday, November 2, 2011

Fiat Money: A Critique

Now let's examine Fiat Money. Let us compare it to the five traits of sound money:
  1. Divisible. Yes. It is denominated in pennies, nickels, dollars, 5 dollars, etc..
  2. Portable. Got that too. Mostly paper and light.
  3. Durability. Sketchy there. Made of paper. It can easily get torn, burned, etc.. 
  4. Recognizable. Absolutely. The dollar is known around the world.
  5. Scarcity. Oops. Not here. The government can print as much as it wants, or lately just hit a button on a computer.
Fiat is a Latin word meaning "let it be so". In other words, by government decree. This is not free market money (more on that below). By law (legal tender law), the dollar is supposed to be used for trade and to pay taxes (in other words, the government does not accept, say, gold or silver for payment), nor can there be competing monies. By doing so, the government actually has, by decree, created a money monopoly. From this monopoly, the Federal Reserve (which is privately owned, by the way), creates dollars and charges interest to the government. Say what? I know. It sounds crazy, but it is true. For the most part, the system seems to work well. After all, the United States is the wealthiest country in the world, right? That is debatable (and a blog for another day), but here I want to focus on the unintended consequences of Fiat Money. What does Fiat money do?
  • Increase the welfare, warfare state. Since fiat money is created out of thin air, the government can have as much produced as it wants (it claims it needs). Government representatives get elected on promises to it's constituents, who always want something from the government. Be it big military contracts or social programs, they all want something from their congressman.
  • No accountability. These programs cannot come into being, or if they do, get out of hand if we had to pay from them from the collective labor and wealth of the citizenry. In other words, the government would have to prioritize where to spend it's limited funds.
  • An increase in the rich/poor gap. The people and organizations that are closely connected to the money supply get first dibs before the new money circulates in the economy. They get to buy the goods and services before the prices go up to reflect the new money. The ones further down the money spigot have to pay higher prices before they get the increased money. In many cases, wages do not keep up with the inflation. And those on fixed incomes? They are the worst off. Their incomes do not go up, but prices do. This leads to a lower quality of life for all except the well connected. Who are they? Bankers, big corporations, politicians, and big contractors that bid for government work among others.    
  • The business cycle. The "elastic" money we have is the primary reason for our booms, recessions, and depressions. It is called "the business cycle". I will devote a full blog on this in the future. 
  • Ultimately, I believe, we will see a collapse of the financial system, dragging the economy (and the middle class) with it. 
Every single one of these problems are the cause of inflation from the fiat money system we have now. Fiat money, since in my opinion it does not store value, is not money, nor should it be called money. It is a currency. It works as a medium of exchange, but it is so flexible you cannot count on it to store your wealth long term.

The use of fiat money has problems. Big problems. So far the powers that be have been able to kick the problems created by fiat money down the road. The problems did not disappear. They are bigger. They are like a wave that keeps getting bigger and bigger. Eventually it will it us, and there is nothing that can stop it.

What do I mean about "free market" money? easy. It is money that comes into use organically by people in the market. In other words, the state does not create nor own it. It is what we choose is money. It would show the five traits listed above, and most importantly, it cannot be created out of thin air. It would represent the true value of stored labor that can be used for capital formation (more factories and better tools for use in production), and sustainable economic growth.

Here is a 5 minute video that explains what fiat money is very well. I encourage you to watch it.


Tuesday, November 1, 2011

What is sound money?

Sound (or honest) money have 5 characteristics. They are;

  1. Divisibility
  2. Portability
  3. Durability
  4. Recognizability
  5. Scarcity (high value in relation to volume and weight)
The first one, divisibility, is important as a unit of account. You need to count things. "It takes 5 of these to get one of that, etc". Portability is for convenience. If it too big or hard to carry, it loses some of it's appeal. Durability is also a necessity. It if wears out or rots, for example, you would have to keep replacing it. Recognizability plays a role in that it is something usable that everybody understands. Let's say someone wants to pay you for your service in a special colored stone from Russia, how much value does it have? Would somebody be willing to trade you his car for it? It needs to be recognizable. The final feature that money needs is scarcity. Why? Quite simply due to supply and demand. The more there is of an item, the less it is worth. As an example, if we as a society decide to use rocks for money, anybody can just pick up a bunch of rocks whenever he wants to buy something from someone else. It does not have value. It is easy to find and use. It would disrupt trade. These are the five characteristics make up sound money.
Why is this important? Because free trade, the division of labor, personal wealth accumulation and higher standards of living count on it.

A little history:

Primitive society started more or less on a barter system. If a hunter landed a buffalo and had more meat than he needed, he could trade a portion of it for some fruit another tribe member collected. Other members may have been better at building housing or clothes, or maybe performed the function of collecting berries. They would trade with each other and with other tribes. This is the beginning of specialization of labor. Some would be better than others at certain tasks. While trade and bartering took place, there were certain items that began to be used as a medium of exchange, thus the first forms of money. The more successful forms of money displayed the 5 traits listed above. An important intrinsic feature of sound money is it's value. It is a way for an individual to save more than he produces for his own use either now or in the future. What was used? Money took many forms. Sea shells, salt, cattle, bear claw are some examples. The most common and enduring forms of money have been gold and silver. These precious metals best displayed the aforementioned five traits of sound money.

And Now?

Now we have what is called a fiat currency. It is paper notes printed by the government and decreed by the government that it is money. At one point, paper money used to represent sound money in that at any time, you can turn in the note to a bank and get the note's  value paid to you in gold or silver. In other words, it was backed by something other than the good word of the issuing government. Is a fiat currency good? No. It has plenty of flaws that lead to big economic problems. That, however, is a blog for another day...