Profit vs Cash - Big Difference for Businesses

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Estimated read time: 6 minutes 18 seconds

1. Profit vs Cash - Big Difference for Businesses

2. Math vs Feelings

Good morning and happy Monday - let's get smarter

Profit vs Cash - Big Difference for Businesses

One of the best things about my time in M&A was the ability to look at multiple different businesses every day

To see their revenue and expense drivers, to see what business models demand higher multiples (bigger valuation) vs not

As I have transitioned into a world of talking with and working with startups and smaller business owner's, I realized there is a big issue

Most people don't understand that PROFIT is NOT CASH

PROFIT = Sales - Costs

That part is very straightforward

However, let's talk about a situation that can put you in a much worse cash position despite having a big sale

Cash is NOT Profit and Poor Cash Management

Let's say you own a big construction company and you just won a contract for $100,000

You have $50k in your business bank account

Hell yeah - that's a big win, $150k cash balance coming in HOT

You think to yourself, this will cost about $40,000 in supplies and direct labor (workers) to complete so that's $60,000 in profit

Well - here's where things get dicey from a cash perspective

Let's say the job will take 1 month and you agree to send the invoice when its complete

You now have to go out, pay for $20,000 of supplies (cash -$20,000) and over the next 30 days you will be paying your workers another $20,000 in labor (cash -$20,000)

You have now put yourself in a bad cash management position, because you have basically floated $40,000 over 30 days without receiving a $

Current cash balance: $10,000 in the bank account

Now after the job is complete 30 days later, you send out a net 30 invoice for $100,000

So here again, you have had costs, you have had "sales", you are making a profit, but you still don't have CASH

Your cash can come after your sales

Continuing this example

You have $10,000 in the bank account and now you have to take on other jobs, and your customer still has 30 days until the invoice is due

What if they don't pay in 30 days?

You have now put yourself in poor cash management position where you have all of your outflows of cash going out before any inflows

You could now go NEGATIVE in your bank account to pay our supplies for the next job and for labor until you receive that $100,000 of CASH

DESPITE having sales

This is common across a lot of businesses where profit is misunderstood for cash and cash management and timing of cash flows is misunderstood

The goal in business is to collect cash as quickly as possible, and pay out cash as slow as possible

On an accrual basis for accounting, this business owner would have recognized SALES on day 1 of $100,000, so the income statement would look GREAT

BUT

Their bank balance as the project progressed would not look great

Math vs Feelings

As humans, one of our biggest bias is the narrative fallacy

I believe this probably comes from our ancestors using stories to pass along information

The narrative fallacy states that people tend to construct a narrative to explain an event or sequence of events that may just be completely random or that has no justification or explanation

This concept really hit me during COVID when I would talk to people about financial markets

They would ALL relay the story that they heard on CNBC but had no statistical facts or math to back it

I would be willing to bet if you ask someone what the stock market will do in 2023 or what oil prices will be, or how TSLA will perform the FIRST thing they will do is tell you a narrative

That's the problem - we make decisions based on our FEELINGS and STORIES we tell ourselves but WE as people are biased

A friend recently asked me what I thought about buying $TSLA stock

Me being a pain in the ass, I said "tell me what you think?"

"Well the stock is cheap and Cathie Wood is continuing to buy....."

Let's analyze this

"Cheap" -> Cheap refers to price

That shirt is cheap or that watch is cheap

PRICE is what it costs but VALUE is what it's worth

If I told you that the value of the car was $80,000 but the price is $50,000

That'd be a great deal right?

If you don't have a sense of TSLA's VALUE to compare to the price, then the price or it being CHEAP is irrelevant

Point #2 -> Cathie Wood

This is the performance of Cathie Wood's ETF over the past 5 years

You could again, say that her ETF $ARKK is CHEAP

But, you'd be again looking at the price and not the value

You see, we are able to tell ourselves a story in our head that might make sense to us and to others, but there isn't data to back any of it up, just human bias

A better way to look at it would be as such:

• What is going on in the macro environment today?

• Is GDP going to slow or accelerate in the US over the coming year?

• Is the fed going to continue to try and slow inflation and raise rates?

• Where will inflation be in 12 months?

• Where will interest rates be in 12 months?

• OK -> now that I have answered all of these ^, how has TSLA performed under these market conditions in the past

No, the past is not a perfect predictor of the future, but it can show us that based on actual data of slowing GDP and slowing inflation, how has TSLA done

I'd rather analyze a similar macro environment and track past performance than use stories

Math > stories and feelings

Now maybe TSLA is too new to have been around during a similar economic period

So maybe you just have no thesis on it and stay away

BUT you have to be careful as well when using data and math

You have to think about how many data points do you have, is there bias in my data, is the amount of time long enough to make a judgement on this, etc

As you can see, the math and the money game are HARD

So instead of thinking and researching data, people use narratives and stories

There are tons of them out there, so be careful who you believe

I can tell you for a fact that if you are interested in stories AND interested in losing money, then I found the perfect person for you!

What's wrong with this tweet?

A few quick items:

1. Taking a sample size of only 2020 on (we've been in an interest rate declining boom for most of this time period)

2. Using a random small sample size of the first 5 days to explain markets returns for a year (more likely than not these have 0 correlation and is purely random)

As the chart below from Artemis Capital shows, depending on your age, you have likely been around during one of the greatest times for both stocks and bond performance

In order to make a better projection, you could take the past 100 years of data as you can from 1900 on there were many different economic overlays, and THEN leverage all of that data to make assumptions and predictions

We're humans and stories rule the world

But remember that we are biased

Think facts, figures, and math

Because as I love to say, "the best part about math is math doesn't give a f*** about your feelings"

• Dev

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.