Why profit is important, but cash is king

Cash flow is the money flowing in and out of a business. It’s what a business needs to fund day-to-day operations and investments, and protect it from financial challenges. And, as we’ve seen with all those ‘profitless prosperity’ companies, it can be the difference between success and failure. So, how do you identify a business that is generating real cash flow, and one that is not?

With all the concerns about ChatGPT taking over the world, banks failing and Russia launching nuclear missiles from Belarus, it’s easy to forget the stock market is a venue through which we invest in businesses that sell things.

We want to own businesses that grow, are profitable and efficient with capital. We also want businesses that generate real cash flow. Cash flow isn’t important when markets throw caution to the wind and greedily buy a fad or when interest rates are so low that buying anything is better than having money in the bank. Eventually, however, the boom ends and may even turn into a bust; when that happens, or when economic recessions result in businesses foreclosing and unemployment rates spiking, cash and cashflow become very important.

Cash flow is sanity

And, given the boom we have seen, up until the end of 2021, in all those profitless prosperity companies, it’s worth remembering you can go a long time without making an accounting profit, but you can’t go very long without making cash. Just remember, revenue and profits are vanities; cash flow is sanity!

Ever had an experience where your business accountant cheerfully tells you your business made a profit and you have a big tax bill, but you turn your pockets inside-out and find there’s no cash to pay the tax?  That’s cashflow!

In an attempt to distract you from the very distracting news investors believe they must keep abreast of, I thought it worthwhile taking you through a simple example of estimating a company’s business cash flow from its balance sheet.

Estimating a company’s cash flow

How would you assess whether a company, at the end of the year – after it had paid its salaries, overheads, suppliers, interest and taxes – had made a real cash return?

The answer is the cash balance at the end of the year would be higher than at the same time the previous year. So, if a company has a higher cash balance, it made a cash profit, right? Well, not really. We don’t know yet.

What we need to understand first is there are ways other than running the business that we can employ to bring some cash in.

The first is to borrow money from the bank. By borrowing money, we increase the debt on the balance sheet, but we also increase the cash. So, before we can determine if the increasing cash balance is one we, as owners of the business, can take to the grocery store to spend, we have to reverse any increase in the borrowings of the business over the course of the year.

Another way we can bring cash into the business is through capital raising. Issuing new shares in the business will also bring cash into the business. (Of course, it will also dilute our ownership of the business – so we really want to be sure we bring in the most money by issuing the least number of shares at the highest possible price).  We, therefore, need to back out, from the increase in the cash balance, any money raised through the issue of new shares.

If we have an increase in cash after backing out the money raised through a capital raising, and any money raised through borrowing, we have made a take-to-the-grocery-store-cash-profit. The only remaining thing to do is to make a final adjustment for any dividends already paid out. Add those back, and you can see whether the business is truly cash generative.

If the business you are looking at has a negative cash number, it may have spent cash on fixed assets or investments, and if they are one-offs, you may be able to look past those. If it didn’t make any acquisitions or purchases during the year and the cash is still negative, it won’t last long.

Watch out for businesses that report a profit but don’t generate cash. They will need to borrow or raise capital or risk going out of business.


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