Fundamentals of Financial Intelligence
Earnings vs. Cashflows: Understanding Profitability
How a company (or person) logs income can be as important as the amount of income itself
There is a curiosity about standard accounting practice that perfectly reflects a standard practice about life. This is that systems are assessed with the assumption that they will go on forever. This is not a denial of mortality, but only a quirk about what it means to be alive: to do anything seriously or competently is to cleave a mental separation from all the temporal space farther out than is relevant to do the work at hand, like the proverbial driving of a car at night. Whether a business will last another two years or two hundred is not the point; to operate it well one must push the fact that strictly it must eventually come to an end into the indefinite horizon. If you are playing a championship basketball game, you can’t spend your time worrying about how if your career doesn’t let up in a few decades you will probably need knee replacements. All long-term projects exist in this kind of suspended animation.
To give an extremely simple example: let's say your monthly MetroCard, or Costco membership expires, and you wait a few days or weeks to renew it because you won’t be needing the subway, or Costco. You haven't really saved any money; all you did was push back the amount of time before you would need to lay out more, in the next cycle. If you had renewed the card right then but then didn’t use public transit for three days, you would have paid for three unused days: 30 days worth of service for only 27. This is an example of earnings in contrast to cash flows — the gain does not provide liquid cash to use and bring back home before being needed again, only to spare you having to shell out more cash for some increment longer.
What should hopefully be clear is that this is only any kind of financial gain if you continue to go on living and earning; if the general trends of inflation and economic growth, the ability to harvest capital, and your juggling of various expenses go on indefinitely. Only over long periods of time will these kinds of incremental gains amount to material, directly financial ones: the moment the trajectory stops and liquidation begins, the very thing with respect to which it is a gain changes its equation. Calculation of ‘earnings’ depends on a system of all relevant variables being in place; cash flow means the ability to allocate directly to whatever is most needed and would help the overall operation (a business, or one’s life). A business is worth more than the sum of its parts precisely because it is illiquid — this exchanged liquidity is the ‘premium’ that gives a non-cash gain its value (in the Metrocard example, the fact that you will continue to need renewals, and will continue to earn, in the future).
The implications of this are extremely important in financial analysis — even financial industry professionals frequently overlook the vital difference between the two and the consequences of the manner of remuneration. Everyone seems to have a favored financial statement — income, cash flow, or balance sheet, and a pop psychology profile surrounding the personalities of each. But businesses are generally oriented toward one or the other. The most straightforward sort of business makes a product and sells it at a markup. But as economies mature and service industries come to dominate product ones, accounting becomes increasingly complex. When you buy a ticket to a movie theater, you are not paying $15 for the piece of cardboard, or even the rented real estate in the seat. Money for the production has been laid out long before your ticket will be sold, as have the negotiations between the studio and the moviehouse. Many businesses lack a clear one-to-one relationship between the “cost of goods sold” and point of sale.
The simplest example would be a vacant hotel room. The “cost of goods sold” for each room represents a measure of the entire operating expense of the hotel — designed to be occupied as much as possible, which means even if the occupancy rate falls within an expected percentage, each vacant means a theoretical outlay for a raw product in exchange for income never received. A hotel room that doesn’t get sold on a given night is a classic “non-cash charge.” Another would be product set to depreciate at a predictable rate. Because businesses exist to make money and not simply consume it, every accounting event is theoretically neutral: an outlay for an asset means an equal decrease in cash as increase in book value of the business. Every month, one month’s worth of that item’s use and depreciation value is “expensed” — reflected on the company’s statements as a reduction in earnings or net assets.
Capitalism and wealth creation are predicated on the time value of money, so this is not mere gimmickry. Not a few businesses have had perfectly sound models and clientele and still foundered because they had to deliver the goods faster than they were able to collect income (having the opposite setup is what has enabled Amazon to grow at such a meteoric rate). Moral of the story: profits are not created equal. Understand their nature in the underlying revenues of any investment you analyze.
