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Get a cup of coffee.
In this thread, I'll walk you through a fundamental business concept that may be counter-intuitive to some of you:
Just because a business has made $1 of PROFIT, it does NOT mean the business's owners have $1 of CASH to pocket.
Get a cup of coffee.
In this thread, I'll walk you through a fundamental business concept that may be counter-intuitive to some of you:
Just because a business has made $1 of PROFIT, it does NOT mean the business's owners have $1 of CASH to pocket.
2/
To understand why, let's start with how PROFIT is defined.
PROFIT = SALES - COSTS
That is, we take all sales (or revenues) the company made during a quarter or year.
We back out all costs incurred during this period.
That leaves us with profits.
Seems straightforward.
To understand why, let's start with how PROFIT is defined.
PROFIT = SALES - COSTS
That is, we take all sales (or revenues) the company made during a quarter or year.
We back out all costs incurred during this period.
That leaves us with profits.
Seems straightforward.
3/
Here's the problem:
The way a "lay person" understands words like SALES and COSTS is completely different from the way an *accountant* uses these same words.
These discrepancies can create enormous confusion.
Here's the problem:
The way a "lay person" understands words like SALES and COSTS is completely different from the way an *accountant* uses these same words.
These discrepancies can create enormous confusion.
4/
For example, a business owner may feel great looking at the financial statements prepared by their accountant.
"Look at this beautiful Income Statement. It says we made $200K of profits this year. Woo hoo!"
For example, a business owner may feel great looking at the financial statements prepared by their accountant.
"Look at this beautiful Income Statement. It says we made $200K of profits this year. Woo hoo!"
5/
Ten minutes later, the same business owner logs in to their bank account.
"Wait. Why is there only $50K of cash here?"
"Where did all our profits go?"
Read on to understand why PROFITS and CASH aren't the same thing.
Ten minutes later, the same business owner logs in to their bank account.
"Wait. Why is there only $50K of cash here?"
"Where did all our profits go?"
Read on to understand why PROFITS and CASH aren't the same thing.
6/
When a normal person like you or me thinks of the word SALES, we picture "cash coming in the door".
And when we think of the word COSTS, we picture "cash going out the door".
So, in our minds, we translate PROFIT -- ie, SALES *minus* COSTS -- to "cash we get to pocket".
When a normal person like you or me thinks of the word SALES, we picture "cash coming in the door".
And when we think of the word COSTS, we picture "cash going out the door".
So, in our minds, we translate PROFIT -- ie, SALES *minus* COSTS -- to "cash we get to pocket".
7/
But to an accountant, that's NOT how things work.
SALES and "cash coming in the door" are 2 different things. They are related. But they are de-coupled from each other in time.
Sales can come BEFORE cash.
Sales can come AT THE SAME TIME AS cash.
Sales can come AFTER cash.
But to an accountant, that's NOT how things work.
SALES and "cash coming in the door" are 2 different things. They are related. But they are de-coupled from each other in time.
Sales can come BEFORE cash.
Sales can come AT THE SAME TIME AS cash.
Sales can come AFTER cash.
8/
For example, suppose we load $100 into our Starbucks Rewards card.
Starbucks gets that $100 right away.
That's "cash coming in the door".
But that's NOT "sales". Starbucks hasn't "sold" us any coffee yet.
For example, suppose we load $100 into our Starbucks Rewards card.
Starbucks gets that $100 right away.
That's "cash coming in the door".
But that's NOT "sales". Starbucks hasn't "sold" us any coffee yet.
9/
The accountants will allow Starbucks to "recognize" this $100 as SALES only when we redeem it for coffee.
That could be weeks/months down the line.
So, in this example, CASH came in the door BEFORE a SALE was made.
The accountants will allow Starbucks to "recognize" this $100 as SALES only when we redeem it for coffee.
That could be weeks/months down the line.
So, in this example, CASH came in the door BEFORE a SALE was made.
10/
The reverse is also possible.
SALES can come before CASH too.
For example, suppose we do contract work for a state or local government.
We may complete the project for them and send them a $100K invoice today. That's SALES.
The reverse is also possible.
SALES can come before CASH too.
For example, suppose we do contract work for a state or local government.
We may complete the project for them and send them a $100K invoice today. That's SALES.
11/
But government being government, they may pay us only after 90 days.
That's when our SALES convert to actual CASH.
And long before that payday, we may have bills to settle. Employees to pay. Etc.
The money for all that may have to come out of our own pocket.
But government being government, they may pay us only after 90 days.
That's when our SALES convert to actual CASH.
And long before that payday, we may have bills to settle. Employees to pay. Etc.
The money for all that may have to come out of our own pocket.
12/
Similar reasoning applies to COSTS.
For example, we may run a coffee shop. We may go out and buy coffee beans for $1000.
That's CASH out the door for us.
But to an accountant, that's NOT yet a COST.
Similar reasoning applies to COSTS.
For example, we may run a coffee shop. We may go out and buy coffee beans for $1000.
That's CASH out the door for us.
But to an accountant, that's NOT yet a COST.
13/
To an accountant, we've simply swapped $1000 of one kind of asset (namely, CASH) for $1000 worth of another kind of asset (namely, coffee beans).
There's no COST in this transaction.
To an accountant, we've simply swapped $1000 of one kind of asset (namely, CASH) for $1000 worth of another kind of asset (namely, coffee beans).
There's no COST in this transaction.
14/
When will this $1000 spent on coffee beans turn into a COST?
Only when we use up those coffee beans to make coffee, and sell that coffee to a customer.
Thus, weeks or months could pass between CASH going out the door and a COST being recognized.
When will this $1000 spent on coffee beans turn into a COST?
Only when we use up those coffee beans to make coffee, and sell that coffee to a customer.
Thus, weeks or months could pass between CASH going out the door and a COST being recognized.
15/
So, here's the rub.
SALES can be recognized before, after, or at the same time as CASH coming in the door.
COSTS can be recognized before, after, or at the same time as CASH going out the door.
So, here's the rub.
SALES can be recognized before, after, or at the same time as CASH coming in the door.
COSTS can be recognized before, after, or at the same time as CASH going out the door.
16/
And that's why PROFITS = SALES minus COSTS during a period may have *nothing* to do with how much CASH we can actually pocket as a business owner -- at the end of said period.
And that's why PROFITS = SALES minus COSTS during a period may have *nothing* to do with how much CASH we can actually pocket as a business owner -- at the end of said period.
17/
Managing cash efficiently is a KEY skill for business owners to learn.
Rent, employee salaries, interest on debt -- can all be paid ONLY with *cash*.
Dividends to owners can only be paid with *cash*.
NOT profits. Cash.
Managing cash efficiently is a KEY skill for business owners to learn.
Rent, employee salaries, interest on debt -- can all be paid ONLY with *cash*.
Dividends to owners can only be paid with *cash*.
NOT profits. Cash.
18/
And the best businesses are those that convert PROFITS to CASH in a *timely* way.
For example, they may collect cash from customers BEFORE recognizing sales.
And they may have enough leverage to pay suppliers AFTER recognizing costs.
As Charlie Munger put it:
And the best businesses are those that convert PROFITS to CASH in a *timely* way.
For example, they may collect cash from customers BEFORE recognizing sales.
And they may have enough leverage to pay suppliers AFTER recognizing costs.
As Charlie Munger put it:
19/
To learn:
- Such accounting intricacies,
- How great businesses manage cash efficiently, and
- How this shines through in their financial statements,
please consider joining this course I'm teaching with Ali Ladha (@AliTheCFO):
maven.com
To learn:
- Such accounting intricacies,
- How great businesses manage cash efficiently, and
- How this shines through in their financial statements,
please consider joining this course I'm teaching with Ali Ladha (@AliTheCFO):
maven.com
20/
If you're still with me, thank you very much!
At the end of the day, PROFITS are an opinion. CASH is a fact.
I hope this thread showed you the importance of following the CASH in and out of a business, and not just its reported profits.
Have a great weekend!
/End
If you're still with me, thank you very much!
At the end of the day, PROFITS are an opinion. CASH is a fact.
I hope this thread showed you the importance of following the CASH in and out of a business, and not just its reported profits.
Have a great weekend!
/End
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