A lot of times in casual conversation I hear revenue, earnings, profit, and even cash used interchangeably. If we don’t know what these things mean, it can look like the health of the business is based on the same crap with different names. So let me quickly break it down.
Let’s imagine that you own a burger joint. In July, customers paid $100,000 for food and drinks. $75,000 of that was paid in cash and credit (money you get immediately), and $25,000 was on tabs that you allow to go unpaid for up to 3 months (this may have been a bad decision by you as a restaurant owner). Your revenue for the month is still $100,000 – in accrual-based accounting, which is the system basically all public companies use, revenue is added as soon as the purchase is made, even if no cash changes hands.
To produce $100k worth of burgers, fries, and shakes, let’s say you had to buy $70k worth of meat, buns, and… whatever milkshakes are made of. That $70k would be your CoGS (cost of goods sold or cost of sales). Then you paid your employees, paid the mortgage, utilities… the stuff that you had to do to make and sell burgers, and it ran you another $15k for the month. That would be your SG&A (selling, general and administrative). Take those costs out of your revenue, and you have your operating income, or EBIT (earnings before interest and taxes). This figure represents money made from your core business of turning money into raw materials, then into burgers, and hopefully into more money than you started with. This number reflects the strength of the business model and the efficiency of your business at producing goods. So our revenue is $100k, and our EBIT (operating income) is $15k ($100k revenue – $70k cost of sales – $15k selling and general = $15k operating income).
Now, some of you see where I’m headed with this. Although you made a healthy 15% operating margin last month, you’re cash negative! Remember, you only collected $75k in cash from your customers, but paid $70k for “raw materials” (burger pun) and $15k for SG&A, so you’re actually $10k short on cash for the month, in spite of making good “profit”! This doesn’t mean you’re a bad burger joint owner, in fact quite the opposite. Revenue is good meaning there’s demand for your product, and profits are good meaning you don’t suck at your core business. It just means you have room for improvement in a very specific area. Maybe we should cancel that policy of letting tabs go unpaid for three months and see if we can get cash positive!
Cash is one of the easiest things to let slide in a growing business, but it’s always the most important thing. Not having enough cash could mean not being able to pay employees, fix critical machinery and facilities, or obtain materials. Extra cash means you can be agile… able to make further investments in growth, able to pay back investors and creditors, or able to take some extra money home. Back to burgers, with $15k positive cash instead of $10k negative, we could, say, buy a new grill, hire an extra cook, save up to open another location on the other side of town, or just celebrate and take some cash out of the business for ourselves. Cash gives you options. We like options.
Of course, this is just an example to illustrate what the concepts mean. Most very small businesses will use “cash basis” accounting rather than “accrual basis,” which means they track their profits and cash much like a household — at the end of the month, do you have more or less than when you started? But it gets considerably more complex as the business grows. Most of the companies we cover, it makes sense to use accrual basis. To use some of our charter companies as examples, it makes sense for Spirit AeroSystems to amortize material and machinery costs as the materials are consumed, as they may be bought months or even years before they’re used. It makes sense for Netflix to spread licensing costs over the time they’re used rather than all at once, because it’s a better reflection of the ongoing business. When payments in, payments out, one-time purchases, and long-term contracts collide, it gets very easy to lose track of how much we actually make, how much we actually have, and where we can stand to improve our policies and practices. Accrual-basis makes more sense in that case, but it sure isn’t easy!
You can tell a company’s problem areas by the numbers. If they have low revenues, it might indicate low demand for their products. If revenue is good but profits aren’t, they probably have operational problems and inefficiencies. If they have good profits but no cash, they might be growing too fast or having trouble collecting payments on-time. Next time you listen to an earnings call, see which of these areas the questions focus on. It’s a good indicator of the health of the business, and it’s consistent across all industries and companies.
So, you’re here on QuarterSense to learn, and our goal is to help you with that. But on the first lesson it should be pointed out that becoming a pro at this stuff isn’t a cakewalk! This is what accountants are paid for, to sort out all of this complexity and make it (relatively) easy to get a snapshot of the business from a few pages. And it’s what executives command high salaries for — not everybody can interpret the numbers, see the problems, come up with actionable policies to fix the problems, and iterate on those policies until the numbers improve… all while managing the strategic direction of the company for the present and future. If it was easy, we’d just keep a corporate bank account and hope it went up over time.
