“All these pieces of paper are issued with as much solemnity and authority as if they were of pure gold or silver; and on every piece a variety of officials whose duty it is, have to write their names, and to put their seals. And when all is prepared duly, the chief officer deputed by Khan smears the seal entrusted to him with vermilion and impresses it on the paper, so that the form of the seal remains imprinted upon it in red; the money is then authentic. Anyone forging it would be punished with death… And nobody, however important he may think himself, dares to refuse them on pain of death. [E]verybody …shall be able to transact all sales and purchases of goods by means of them just as well as if they were coins of pure gold…[T]his paper money … is also vastly lighter to carry about…
Marco Polo reporting his observation of the use of fiat money in Kublia Khan’s empire (as quoted in Goetzmann, W., Money Changes Everything: How Finance Made Civilization Possible, 2016). Also see https://bigthink.com/sponsored/mongol-empire-paper-money/.
Bitcoin (₿) is a cryptocurrency invented in 2008 by an unknown person or group of people using the name Satoshi Nakamoto … It is a decentralized digital currency without a central bank or single administrator that can be sent from user to user on the peer-to-peer bitcoin network without the need for intermediaries. Transactions are verified by network nodes through cryptography and recorded in a public distributed ledger called a blockchain. Bitcoins are created as a reward for a process known as mining. They can be exchanged for other currencies, products, and services.
https://en.wikipedia.org/wiki/Bitcoin#Creation accessed at 10:42 pm EDT on July 18, 2020.
Cash and Cash Equivalents
We all know intuitively what cash (currency, money) is, but these two quotes highlight some important aspects:
- It was a remarkable invention.
Marco Polo’s reaction upon seeing paper money used in China was amazement. Here is the title of the section quoted above: “How the Great Khan Causes the Bark of Trees, Made into Something Like Paper, to Pass for Money All over His Country.” Polo was familiar with money, but equated it with something of inherent value, such as gold or silver. What is important about money is that people accept it.
- Acceptance is the key.
Khan’s method of ensuring acceptance was to use the threat that physical violence would be visited upon anyone who refused to go along. Bitcoin has evolved without being enforced with power. It is accepted only because enough people expect enough other people to accept it. No “under pain of death” required.
- Money is used to reduce transactions costs
Paper money was lighter than coins and easier to transport. Electronic money is simply an electronic record, and can be transported much more readily than paper.
Money represents rights – the right to settle debts and acquire goods and services. These rights are, by definition, the most liquid of assets, meaning cash is readily converted into other assets or used to extinguish debts.
Further, to put a value on these rights, all we have to do is count them. That is, the value shown for cash on a balance sheet is simply the amount owned or controlled by the entity. There is no need for fancy valuation methods, as long as the entity uses only one kind of cash. (When it transacts in dollars, Euros, Yuan and Bitcoin, etc., we have to pay attention to how the rights represented by these different forms of currency compare to one another at various a points in time, and things get complicated. We will put that aside for now and consider entities that use only one currency, dollars.)
Cash comes in many forms:
- Currency - coins and pieces of paper that governments issue for use in making economic exchanges. Multi-national organizations will hold currencies of several governments to quickly engage in necessary transactions.
- Checking Accounts - amounts on deposit in checking accounts are also cash. Many companies issue checks that can be deposited into accounts and used as cash.
- Savings Accounts, Money Market Funds, Short-term Government Securities, etc.- These earn interest, but can be converted to currency or electronically transferred very quickly in an easily determinable amount.
Restricted Cash
Many organizations hold cash that is restricted in its use. Here is an example from the Chembio Diagnostics, Inc., Form 10-K for the year ended December 31, 2019:
The Credit Agreement also contains financial covenants requiring that (i) we maintain aggregate unrestricted cash of not less than $3,000,000 at all times …
Here is another example, from the Bio-Rad Laboratories, Inc., Form 10-K for the year ended December 31, 2019:
[ Bio-Rad 10-K, Bio-Rad Financial Statements only ]
Restricted cash is still an asset, but it is not included in Cash on the balance sheet because it is not liquid; i.e., the entity cannot use it for any purpose other than that for which it is restricted.
Cash Flow
Cash flow is simply a change in cash.
A change in cash can be an increase (inflows to the entity) or decrease (outflows from the entity). The cash flow statement describes the changes in an entity’s cash over a period of time by grouping the increases and decreases into a set of categories that describe the activities that caused them. The three main categories of the cash show statement are cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.
Here is an example of a cash flow statement for Chembio Diagnostics, Inc.:
[ Chembio 10-K , Chembio Financial Statements only]
Investing Activities
Investing activities are actions aimed at acquiring and disposing of assets that generate a financial return over a long period of time.
These can range from the acquisition of PP&E to purchases of other businesses. You can see from the exhibit above that Chembio spent $3,502, 540 acquiring and putting deposits down on fixed. Investing activities resulted in a net disbursement of cash in the amount of $3,753,786.
Financing Activities
Financing activities are actions aimed at acquiring and repaying funds to be used over a long period of time.
Their main aim is to raise cash to fund operating and investing activities. This can be done by incurring long-term debt or issuing common equity but as financial markets get more sophisticated, these instruments may no longer fall into the clean cut debt and equity classes. We can see that Chembio raised $18.85 million by issuing long term debt.
Operating Activities
Operating activities are actions that are neither investing or financing activities.
These include selling to customers, compensating debt-holders for using their money, acquiring and selling inventory, and using labor. Generally, operating activities involve producing and delivering goods and providing services. In the exhibit above, the net of these operating activities consumed more than $9 million. Operating activities are very much at the core of an organization’s purpose. Public corporations are formed to generate a financial return to owners through their operating activities. For this reason, understanding the cash flows from operations is key to understanding the financial performance of an organization.