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.