Cash Rules and Income Comes Second
August 18, 2009
There’s one very important lesson I learned while earning my MBA, which I keep in mind in my personal life. When valuating a business, figuring out what a company is worth, there are a couple of different ways to come to a figure. The easiest method is calculating the fair market value of all of the company’s assets, subtract its debt, and the difference is its value. You can also look at accounting ratios and future earnings, and then it gets really complicated. But the best way to know if a business is worth buying is by analyzing its cash-flow and how easily it generates free cash. When payroll is paid, when your accounts payable are up to date, is there still cash left in the bank? Is the cash reserve increasing over time? I think the best way to valuate a business is by looking at its free cash flow.
Suppose you are evaluating a potential purchase of a restaurant. The current owners invested over a million dollars in the kitchen and dining room, but it makes no cash profit. Is the restaurant worth a million dollars, as the value of its assets would suggest? Certainly not; not if it does not produce cash.
There are many businesses that have great ideas, develop excellent products, and generate healthy revenue, but they fail because they run out of cash. In fact, the number one reason small businesses fail is running out of money, and the second reason is that management doesn’t know how to manage their cash and raise capital.
Everything I just discussed about businesses and cash also holds true for individuals. While looking at your balance sheet from time to time is prudent, to gauge your net worth, looking at your cash position constantly is more important. You can own lots of real estate, cars, boats, and have a lavish lifestyle, but as soon as you run out of cash it all goes away very quickly. A lot of people live lives they can’t afford and don’t even realize it because it’s all financed and mortgaged off to the bank.
Let’s go back to the business analogy for a second, and I’ll give you an example. Let’s compare company A and company B. Company A is a small furniture manufacturer. It purchases lumber from a mill on credit, due 30 days. Its biggest customer is a large multinational retailer, and it pays for the furniture only after it has been sold to the end customer. Therefore, the inventory is owned by the manufacturer until it is sold, sometimes longer than 45 days after it’s made. The company makes payments on a small building, and also financed the capital equipment used to manufacture the furniture. Employees are paid bi-weekly. On the balance sheet, the company owns $1.5 million in assets, while it carries $1 million in debt. It has a net worth of $500K. It enjoys a healthy profit on its furniture, but sometimes the product sits on shelves for up to 60 days before being sold. By the time the retailer transacts a sale for one dresser or armoire, the company has had to pay for its supplies two times, and pay its employees 4 times, sometimes running out of cash. Often, the company resorts to borrowing money from the bank to meet its payroll obligations. Harsh reality, but it happens.
Company B is an internet reseller. It displays items on its website for other companies, brokers the deal, and charges its internet customer a very small margin over the cost of the product. The products ship directly from the manufacturer. The company owns no inventory, no manufacturing site, and has less than 15 employees. It collects payments from its customers through credit card transactions, which are deposited into their account within 3 days. But it pays its suppliers after the products are received, sometimes up to 15 days. Since the company doesn’t own any inventory, warehouse, or capital equipment, its balance sheet is very small. However, because it collects payment faster than it pays its suppliers, it accumulates cash in the bank. The company never has any problems paying its employees or suppliers on-time.
If you could be owner, which company would you choose to run? Wouldn’t you feel more comfortable and have more piece of mind running company B?
Personal cash-flow is just as important and necessary to having piece of mind. Imagine not having to worry if your mortgage will be late this month, or if you have enough cash in the bank to pay for your weekly supply of groceries. Ever walked up to an ATM machine wondering how much cash you could withdraw without taking too much and then bouncing a check? How long would your utilities and creditors keep accounts open with you if you could not pay them on time every month? It’s not only how much you make, but how much cash you have on-hand. Even highly paid professionals can get into financial trouble, and eventually fall into bankruptcy for protection from creditors.
The take-away is that in business just as in your personal life, cash is king. Cash rules, and income is not as relevant when it comes to measuring or generating wealth. Higher incomes may appear to generate more wealth, but ultimately it comes down to how well you can manage your cash flow and generate free available cash.
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