Making Money Is Not The Same Thing As Making A Profit

A business is worth what it can earn. The what in this case is cash.

The financial press is carelessly preaching about value using different ideas about making money. For people who do not have any kind of deeper understanding, it quickly becomes confusing. Confusion is a destroyer of rational thought.

Understand cash and cash flow.

I suppose we all know what cash is. Currency, bank account balances, callable deposits, and maybe marketable securities. On a balance sheeet cash is real. People tend not to tamper with the number because it is easy to verify and the auditors would catch it every time. Then you go to jail.

Every other number on the asset side of a balance sheet is opinion.

Most assets in a financial statement are opinion

Assets

  1. Accounts receivable – how much will be uncollectable?
  2. Inventory – How much will be lost, damaged, or become obsolete before sale.
  3. Work in progress. – A guess based on what is spent so far. Worth is unknowable.
  4. Fixed assets – historic cost less some made up depreciation number.
  5. Goodwill, deferred R&D, patents, trademarks, and copyrights. – Just waiting to be allocated to earnings.

Most liabilities are real, but some liabilities are guesses too.

  1. Pending lawsuits – no one knows what will happen in court and legal fees are onerous
  2. Pension obligations. An actuarial assessment of future required payouts based on employees’ age now, estimated duration of life after retirement, the salary now, maybe some inflation or promotions, maybe some turnover in the work force, all discounted by a made up interest rate. From that number deduct what assets are already in place. Usually market securities with no certain predictable value. A multivariable guess.
  3. Unearned revenue. A formula guess.

Cash flow is real too

Cash flow is harder because there are several factors. For a business we can assume is a going concern and likely to remain so, cash flow might be how much the bank accounts go up this year. I have known farmers who keep track of profit that way.

Speaking of profit, the earnings number you see, earnings per share, is all opinion. I know a person who was a senior executive for a major league baseball team. I asked him once how a team that loses $5,000,000 per year could have such a huge value. His reply, “You know if you can’t turn a five million dollar profit into a five million dollar loss with one one well-reasoned journal entry, they will come and take your accounting diploma away.”

Pay little or no attention to earnings. Noone can pay dividends with journal entries.

The common idea for cash from operations is EBITDA. Earnings Before Income Tax, Depreciation and Amortization. Much more useful, but still not enough for rational decisions. Does depreciation make sense. Someday the assets must be replaced. Machinery, trucks, and even buildings wear out or become obsolete. Amortization of goodwill assets is just an allocation. Did you know that in the 90s banks in Japan could write of bad loans at the rate of 2.5% per year for 40 years? Amortization is often, maybe usually, more useless than depreciation. Income taxes in an operating statement might be due now or maybe not. Maybe zero, maybe double or more. Deferred taxes store the illusion.

The only word in EBITDA that is not a guess is “Before”

Free cash flow is something you want to know about. Free cash flow is what cash remains after you pay all the bills, pay dividends, replace assets you use, pay down long term debt, finance working capital, and build for the future. It might be similar to earnings and/or EBITDA but usually not. Free cash flow is what you the shareholder might get someday.

Understanding free cash flow versus earnings and EBITDA is a useful exercise. Suppose you “earn” $1,000,000 this year. Suppose EBITDA is $1,400,000. Not bad. A million is good, $1.4 million is nice. BUT, what if new equipment to stay competitive was $800,000. Suppose you paid $200,000 in principal on bonds or loans. Suppose taxes were $300,000, Suppose inventory and receivables went up 200,000. Suppose you spent but treated as deferred $200,000 in R&D also to stay competitive in your industry. Net free cash flow = negative $300,000.

Essentially you stayed in your place in your industry and did not lose much money in the process. You had earnings, but you did not make any money. Now what? If you are the industry leader or maybe #2, your investments should create more cash flow in future, but if every year looks like this one, you will go away. Even while profitable.

Because the business must take on new debt to continue to pay their bills as they come due. Sort of like the government.

Amazon has only recently begun to have net earnings, but they have a lot of free cash flow. You might wonder why. Hint: they don’t pay their venders very quickly. Retail does not make a lot of earnings but it spins off a lot of cash. Amazon Web Services makes most of the earnings and likely makes little “money.”

Cash gives you choices.

In life and in business if you have options, you are likely okay. Cash lets you build choices. Choices give you some control.

Try to avoid investments that must work a certain way or fail. Eventually they will fail. No business is immune to outside factors.


I help people understand and manage risk and other financial issues. To help them achieve and exceed their goals, I use tax efficiencies and design advantages. The result: more security, more efficient income, larger and more liquid estates.

Please be in touch if I can help you. don@moneyfyi.com 705-927-4770

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