Don't Confuse Cash and Profits

In the words of one famous investor, easy cash sedates reality and leads to sloppy decisions. When a business or person (witness half of Hollywood in the early, ephemeral period of their careers when money and roles are easy to land) finds themselves in the position of having cash poured on top of them from what seems like a never-ending spigot, they tend to do incredibly stupid things, chief among which is increasing the level of fixed expenses they must pay just to maintain their position. That’s why you hear of so many formerly great businesses that are now struggling and musicians on “Behind the Music” who declare bankruptcy, sometimes at the height of their popularity. All of this could be avoided if people understood one simple concept: Cash is not profit. Okay, now that you’ve let that sink in for a moment, read it again. Think about it.

This mistake is committed, quite often it seems, by small businesses. In a drive for ever-increasing sales, they push forward – a few more hundred thousand in sales … a few more million in sales … it never ends. In some businesses, what the owners don’t seem to realize is that they will make more money by drastically cutting their fixed expense structure and a substantial portion of their sales. In some businesses, wholesale operations are more profitable than retail. Yankee Candle, prior to being acquired in a private equity, consistently displayed this reality. The company’s retail stores generated far less than wholesale operations because, although the former allowed products to be sold at nearly twice the price, the latter had far fewer expenses as a percentage of revenue; costs were confined to a huge manufacturing facility in Massachusetts.

One of the industries notorious for confusing cash and profit is insurance. A good property and casualty insurance business can go decades doing the right thing, compounding shareholders’ equity at a respectable clip. Sooner or later, it seems, a few overeager managers, excited by the huge piles of cash coming in the door, start writing bad business (policies for which they aren’t paid enough to assume whatever risk it is they are underwriting – hurricanes in the golf coast region, fires in a major city, earthquakes in California, etc.) In the beginning there are no expenses. Policyholder premiums show up in the mail and are deposited into the company’s bank account. Fast forward several years, or decades, and the situation can get quite ugly. Take asbestos. A policy that cost a few thousand dollars could have literally resulted in millions of dollars in losses. An investor or manager that didn’t understand this would have wanted the employees to continue writing policies, collecting checks in the beginning. Yet it would have cost them everything.