Some Clarification on "Profits" Posting

A good friend and colleague suggested the post preceeding this one might be somewhat confusing to anyone who has not had to deal with cash flow in a business; versus cash flow at home or in one's personal life. He is right, of course...and I felt it necessary to explore the idea in more clarity.

To remind; I was explaining how a business's cash flow, in different stages of the operating cycle, could distort short-term tax returns in a way that would falsely indicate the business had benefitted from a sudden increase in profit. I brought up the issue due to a government agency that made a public announcement that profits were up across the business sector. They contended that the recession must be over as a result.

Quarterly tax returns tend to show the ups-and-downs of cash flow more dramatically than a yearly tax return, and most businesses have to file quarterly. The longer time period of a full year simply "smooths" out the fluctuations in cash flow and gives a more accurate picture of what the firm is doing. The agency was speaking about quarterly tax returns.

Here is a good visualization of the "operating cycle."

Imagine a circle graphic with a box at 12 o'clock labeled "Cash." There is another box at 3 o'clock labeled "Raw materials", a box at 6 o'clock labeled "Inventory", and one at 9 o'clock labeled "Accounts Receivables." We will go around this circle in a clock-wise direction.

What this graphic represents is the assets the company has at different points of the "operating cycle."
At the beginning of the cycle the company has cash, it might be their own or from a loan, or a combination of both. The company begins by paying out money in the first stage of the cycle to purchase materials. Money going out of the firm would also be for payroll costs and other needs.

A cash flow statement at this point shows the purchase funds coming in, from prior sales and/or as cash from a loan, and then going out, to purchase raw materials. On the tax return, however, we simply see the cost of raw materials as an expense. Loans are not income...anymore than the use of a personal credit card to purchase something for your home is a source of income.

(Admittedly some folks use their credit cards as "income" and that does get them into a whole world of hurt in the long run.)

At this point, we show no income as the company has nothing to sell. In the next stage we see the raw materials being worked into finished goods and the goods being stored as inventory. Again, our tax return will show no income, but will show expenses as we pay for labor. The assets are now all in inventory.

Now imagine this firm's operating cycle is one year in length...perhaps they make toys for the Christmas season. Our quarterly tax returns show large losses in quarters one and two: the first quarter mainly for materials, and the second mainly for labor. This corresponds to the first two stages of the operating cycle.

In the third quarter, or third stage of the cycle, the sales process takes place. We may well be receiving some income now, as some customers will pay cash up front to obtain price breaks, but most of our actual revenue will come back in the fourth stage, the collection cycle. Most of our assets have now been converted to Accounts Receivables...or money owed by purchasers to the firm. This takes place in the third stage of the cycle.

Hopefully, the firm receives its money in the fourth stage of the cycle. In our annual model, that is the fourth quarter.

In a strong economy, we might already be buying more materials and paying for labor in the third and fourth quarters, so the income coming in would be offset by those expenses. We would also have the expense, in the fourth quarter, of the company paying back the loan that began the process. Therefore, we might be showing a profit in those quarters, but it would be largely offset by the new expenses of replacing inventory and the repayment of the loan.

But in a recession, we would be laying off workers in the third and fourth quarters as demand for future product falls off. We would also be purchasing less materials for future production. As a result, expenses are suddenly less than they have been for years.

The result: almost all the annual income comes in during quarters three and four, yet expenses are now reduced. Income minus expenses equals profit...and the profit number will be higher than in the previous year, or operating cycle, as we have reduced expenses. The profit figure will also be far higher than in quarters one and two. To the uninitiated, the quarterly tax returns make it look like this business is suddenly "booming" with cash...so they must be "profitable."

Here's the rub: the firm is producing less product than the prior year...so what do you think will happen during the next sales and collection cycles? If you guessed that sales and profits would go way down...you are right. The "booming" profits in cycles three and four are simply a fluke...and actually foreshadow what will be a dramatic reduction in revenue and profit.

It's like a last, dying gasp. The patient raises his head...speaks one more time...then collapses and is gone.

Which is exactly what could happen to this company and others like it. Almost all companies have some sort of operating cycle...and many are keyed to the holiday season as being the sales and collection parts of the cycle. Even those that are not tied to end of the year sales will show sudden spurts of profit during a recession as they reach the third and fourth stages of their cycles.

So in one respect, the government folks are correct...the quarterly returns show profit. But when the year-end returns come in they will tell a very different story, because all four stages of the cycle will be reflected.

The truest measure of the end of a recession is when employment figures begin to go up...instead of down. There is a dark side to recovery however, that may well be the death knell of many firms. As an economy begins to recover, and demand is forecast for finished goods, firms need to begin buying raw materials and hiring people once again.

Some of them simply won't have the cash to do so without help from a lending institution. Unfortunately, with a tough year behind the borrower, lenders may well decline to offer funding. As other firms get product on the shelves, these less fortunate ones will end up losing their market share and will be forced to shut down...even as a recovery is well under way.

Of course not every business has a long operating cycle...a restaurant brings in fresh foodstuffs in the morning and by evening they convert this material into meals and have collected their money. But the greater part of our economy, and the part that supplies a significant portion of wages that translate to consumer spending, is made up of manufacturing, wholesaling, and distribution firms. All of these are subject to these long operating cycles.

I hope this makes it a bit clearer to those who have asked for such clarification. Though not as scintillating as some of our conversations, it is an eye opener to the true current situation and the lack of business expertise in Washington DC at this time.

Hopefully...they will seek out and find experience and advice before much longer. Heaven knows we need help in the business sector, where jobs are actually produced, a lot more than we need more excuses for even more taxation.

Now that you understand the operating cycle...you can understand how increased taxes simply drain money out of the operating cycle and require the business to make less product and lay off more workers. I don't think our elected officials have figure that one out yet...especially when taxes are so often levied against phantom profits.

The Professor