Don’t Confuse Cash with Profit
Cash flow is all-important; without the ability to meet your financial obligations when they come due, you won’t be around to play the game. Never forget, however, that all that matters at the end of the day is profit (more specifically, the return on capital employed).Imagine, for example, you own a successful furniture business. Over the past decade, you’ve built up a comfortable working capital position in the form of increased inventory; your storefront has expanded and the show room now holds thousands of individual pieces of merchandise. One day, you realize that you’ve grown tired of the industry. You think it’s boring, you’re weary of dealing with the same people, and you think that cookie baking is far more exciting. After discussing it with your spouse, you make the decision to shuttle the furniture store, liquidate the inventory, and open your own dessert shop. You inform the store manager of your decision, and instruct him to discount all of the merchandise heavily. You then place ads in the local papers and on the news channel advertising a “going out of business” sale.
The week of the sale arrives. There is a tremendous customer turnout and you are generating tons of cash; far more than you’ve seen in the normal course of business. You reinvest little of this in new inventory for the business (you are liquidating, after all). Instead, you use it to begin preparations on your new venture; moving expenses, paying down some personal debt, buying a new home, and such.
Here’s the problem: Unless you have an excellent bookkeeping system, you won’t have a clue how you fared, in economic terms, from the liquidation. If you were an accountant by training and knew the specific identification method, you could simply plug in the sales figures to your software and instantly calculate the profit. If, however, you are like many small businesses and you are more entrepreneur than financier, you may not be aware of the cost associated with each of the items you are selling. The result? The dining room table you sold for $60, marked down from $130, actually cost you $75 three years prior! On an accrual basis, you’ve experienced a very real loss of $15 on that sale. Yet, the check you wrote to pay for that merchandise is long forgotten; the cash in your hand is not. The larger the business, the more significant the problem; you could experience a drastic shrinkage in real net worth while thinking you are making a tremendous amount of money. The torrents of cash coming into your life mask economic reality, placing your finances in an extremely vulnerable position.
The Bottom Line
Know and understand the accrual concept. Understand how it differs from cash flow. They are not mutually exclusive and it is necessary for both to be healthy for your investments to work out well. To learn more, read Investing Lesson 3: Analyzing a Balance Sheet.
