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27 May

Profit isn’t cash. Only cash is cash.

“People with limited understanding of business think that business is all about making profits. But those who actually run businesses know that running a business is all about managing cash flows.”

— Cedric Chin

You can have a lot of profit but not have a lot of free cash flow. And you can show little profit while having a lot of free cash flow.

Few people understand this.

But first, what is the difference between profits and free cash flow?

Let's say you own a lemonade stand where you sell a glass of lemonade of ₹20, on which you have a ₹10 profit margin. A friend who comes to you every day for a glass of lemonade tells you,

"I find it hard to carry ₹20 every day, so why don't you keep an account of the lemonade I buy everyday and I'll pay you the total sum at the end of every month."

If you have 5 such friends who buy a glass of lemonade from you every day and pay you at the end of the month, you are earning ₹10 x 5 = ₹50 in profits every day.

But your free cash flow every day is still unimpacted as you are not getting paid till the end of the month.

This is essentially the difference between profits and cash flow. You can have a huge profit margin but you still don't have consistent cash flow.

Why is consistent cash flow important?

To serve those 5 lemonade glasses every day, you are spending ₹50 every day which is spending ₹1500 in 30 days. If you aren't getting paid in cash for these and the profit is just registered in your accounting books as "accounts receivable", you need to put ₹1500 out of your own pocket to be able to continue running that lemonade stand.

Now, if you have 100 customers buying a glass of lemonade from you each day, you can still afford not to get paid for 5 of them till the end of the month.

But let's say due to unforeseen circumstances, business plummets and you only get 7 customers on a given day, out of which 5 aren't paying in cash. Now you risk leaving yourself in a position where you have a lot of profit on your books but no cash to continue running daily business operations for the next day.

You will need to shut down the business.

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. We hate that second kind of business."

— Charlie Munger

The restaurant business is a great example of a business where a lot of cash expenditure is needed to run daily operations. Most of the cash you earn on a day has to be reinvested the next day to keep the business running.

That's an example of a business with bad cash flows.

"That's why experienced veteran investors like Warren Buffett and Charlie Munger like to make a distinction between "Maintenance CAPEX" and "Growth CAPEX".

Maintenance CAPEX is when a company has to spend cash today simply to preserve its current earning power. In other words, if this cash is not spent, earnings will be hurt. The company has no choice. It cannot distribute this cash to owners without hurting itself.

Growth CAPEX, on the other hand, is cash that's spent to increase earnings. There's no obligation to reinvest the cash. If this cash is distributed to owners, there will be no adverse impact on future earnings. They may not grow, but they won't shrink either. So, the company's management gets to choose whether to re-invest this money or return it to the owners.

For example, management may decide to re-invest only when they feel there's a high likelihood of earning very attractive returns on such re-invested capital."

— @10kdiver

Businesses that choose to report no profits but have great cash flow

There are also examples of businesses like Jio and Amazon that can report no profits while having excellent cash flows and use this as a competitive advantage.

Allow me to explain.

Take the example of the telecom industry — where setting up the business takes high upfront infrastructure costs. But once you build this infrastructure, it becomes a moat. You create high barriers to entry for new competitors. Consequently, you can enjoy highly predictable, monopoly cash flows for a long time afterwards.

At the same time, the telecom industry has highly predictable subscription revenues with good customer lock-in. Subscribers pay monthly or quarterly and rarely cancel or port numbers, especially if the phone number is registered with banks and other organisations.

Hence, many companies in the telecom sector show a high debt/equity ratio, meaning that they use debt to finance their growth. The logic —

If you use debt to finance growth, you can keep growing the company, and use the depreciation on acquired technological systems (plus the write-offs from the loans themselves) to delay paying taxes on the cash flow.

You're essentially deciding to reinvest all your cash into growth, so there aren't any profits to report and pay taxes on. Simultaneously, you keep increasing in size, so your cost of acquiring customers decreases and you can now spread these costs across your entire customer base.

You also prevent newcomers from entering your business. It's a long term strategy where you invest free cash flows back into the business today to earn even more cash in the future.

In fact, Jeff Bezos, in 1997, explicitly wrote in one of his investor letters that he was adopting the same strategy:

"We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.

We will continue to measure our programs and the effectiveness of our investments analytically, to jettison those that do not provide acceptable returns, and to step up our investment in those that work best. We will continue to learn from both our successes and our failures.

When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we'll take the cash flows."

What Bezos means by GAAP accounting is accounting that focuses on profits, not on cash flows. He chose to go with the latter.

So, although Amazon hasn't reported profits for many years, it has always had excellent cash flows which it used to expand its business and become the unassailable force it is today across various business verticals.

So the next time you think about whether a business is profitable, a better question to ask would be

  1. What kind of profits is it generating? Are they paper profits or cash in hand?
  2. Does the nature of the business require this cash to be compulsarily reinvested so that profits don't take a hit? Or can it do whatever it wishes to do with that cash?

If you have disposable cash in hand, you can weather market volatility better. It's also a good signal for the value you're delivering to your customers.

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