One of the most fundamental concepts in finance is “cash is king.” Most people find income statements intuitive. Sales minus cost equals profit; what could be simpler? Hence many people think about starting, investing in, or running a “profitable business” where profit (the bottom line) is attractive. However, few realize the difference between profit and cash, and often realization comes only when they are trapped in a cash crunch. (If you have experienced cash crunches before and can understand very well why it is critical to monitor and plan cash flow rather than profit, you can skip this chapter. You already know the key principles.)
If you are unsure why cash is key, take a look at the examples in Tables 10.1 and 10.2. It is an exaggerated example to illustrate the importance of looking at cash rather than profit.
The company had no sales last year because it was being set up, but the projection for the current year is 100 percent guaranteed. Would you buy Y at US$100,000? It looks like it cannot be that Table 10.1 shows how you can make your money back within the year!
But would it make a difference if you were to learn the following tidbits:
Table 10.1 Projected Profits
| Company Y Annual Profit and Loss for the Current Year (US$) | |
| Revenues | 1,000,000 |
| Costs of goods sold | 400,000 |
| Salary, rent, other expenses | 300,000 |
| Net Profit | 300,000 |
Now what? All of a sudden, the financials are changed. Your cash flow projections for the year will look like Table 10.2.
So, you won’t just need US$100,000 to purchase the company, you also have to have US$700,000 cash to operate the business in the first year! You will then get the projected US$1 million in revenues after the first year. Therefore, as Harold Williams, the former chairman of the Securities and Exchange Commission, commented in Forbes, “If I had to make a forced choice between having earnings information and having cash flow information… I would take cash flow information.”1
Table 10.2 Projected Cash Flow
| Company Y Cash Flow for the Current Year (US$) | |
| Revenues collected | 0 |
| Costs of goods sold | 400,000 |
| Salary, rent, other expenses | 300,000 |
| Net Profit | −700,000 |
Profit is an abstract entity. Profit is not tangible. You cannot touch or count profit. You cannot pay your bills with profit. Only cash is real. Your suppliers will gladly accept your cash—but not your profit. In one extreme case I saw, one of my clients sold his products to a company that subsequently went bankrupt. The company was profitable on paper. However, to push sales, the company’s management gave its customers a 24-month installment payment plan. To make it worse, no one at the company was following up with the customers to collect. Salespeople considered their jobs done once a sale was made. Also, since maintaining a good relationship with customers was important, salespeople did not see any benefit in pushing for on-time payment. On the other hand, finance department was mostly made up of clerks and bookkeepers. They were very diligent and accurate in recording payments when the payments arrived but they did not see getting the payments in the first place as their responsibility. Unfortunately the bank was not as “disorganized” as my client was. My client’s company was forced into bankruptcy after it defaulted on a few payments owed to the bank.
In the same way, the more time you get before you actually have to pay your expenses, the better it is for your cash flow. It is well-known that the travel agency business in Hong Kong has very thin margins. I was told that in some cases an agent makes only US$2 to $3 on a US$300 air ticket! So why are there still so many travel agencies? One of the reasons is cash flow. Travel agencies get you to pay prior to your trip but they often do not pay the airlines, hotels, and restaurants (for package tours) until much later. In the years before the 1997 Asian financial crisis, many travel agency owners would use the cash flow to invest in real estate. All became very rich, though many lost a significant part of their wealth after the crisis.
Cash is king but cash that has already been spent and is largely irretrievable probably should not be considered in future decisions. This is the all-important “sunk cost” concept. Here is a trap that is easy to fall into:
Many people fail to apply sunk cost when they are making decisions.
There are a variety of reasons for this:
Hence, it is easy for even experienced businesspeople to fall into the sunk cost trap. Sometimes, decision makers have to be replaced so an organization can avoid the sunk cost trap. In the Harvard Business Review article “The Hidden Traps in Decision Making,” the authors cited a real-life example:
One of us helped a major U.S. bank discover that bankers responsible for originating the problem loans were far more likely to advance additional funds—repeatedly, in many cases—than were bankers who took over the accounts after the original loans were made.… had tried, consciously or unconsciously, to protect their earlier, flawed decisions. They have fallen victim to the sunk-cost bias. The bank finally solved the problem by instituting a policy requiring that a loan be immediately reassigned to another banker as soon as any problem arose.4
For most companies, regular financial statements including the income statement, balance sheet, and cash flow statement are generated regularly by accounting staff using accounting software. Key measures can be read off or calculated from these statements based on definitions approved by authorities (accounting rules, tax laws, rating agency guidelines) and by management.
To explain the construction of financial statements and all the possible key measures that can be derived from the statements is beyond the scope of this book. They are not difficult, just full of details. (A slight digression here: I strongly advise that anyone interested in business should take at least a course in accounting. I had one course in accounting during my undergraduate days at Stanford. The key principles I learned there have served me well even to this day. A degree or an accreditation in accounting would have been even better, even for someone who does not want to be an accountant. Besides in-depth knowledge that is useful in management, such qualification can also open the path to a career as a CFO, which could be another way toward becoming a CEO. Without the academic qualification, such a career path is not even an option.) HBS does not teach details of how to prepare financial statements. Such data is usually already provided in the case studies. It is assumed that in real life, these statements would be prepared by qualified accounting personnel. Therefore, the focus at HBS is on mastering how to exploit the financial statements to get the data necessary to make critical decisions. The key is asking two questions— “why?” and “so what?”—and then answering them with data and logic.
Why
Asking why forces the discipline of identifying root causes. In finance, causes are often called drivers: revenue drivers, cost drivers, growth drivers. By identifying and managing the drivers, management can use them to push revenues up and costs down, and to accelerate growth.
So What
“So what” questions should be tirelessly asked until it drives you and everybody a little crazy. This includes asking:
If you are getting financial data that won’t allow any of these questions to be answered, then the question becomes “so what are we doing collecting and looking at this data?” I have seen many long financial (or operational) reports filled with detailed data. But much of that data was never really read or used by anyone. Such data collection becomes a routine and no value is created.
I have included a real-life example of using “why” and “so what” in Appendix A. These two questions are powerful in helping to identify root causes and critical actions. But care must be taken not to alienate people. While some people (maybe your boss) will be impressed by your active and strategic thinking, many others (especially your equals) may react negatively for a variety of reasons:
If people are alienated, they will not support your brainstorming wholeheartedly. Worse, they may become your political enemies and try to sabotage your effort behind your back. As a result, think carefully about how and when you ask these questions. Some possibilities of making the whys and so-whats less alienating:
In short, unless you are with a group of people totally open-minded on brainstorming, it would be advisable to plan and ask the questions in a politically sensitive manner.
An interesting illustration of the need for caution with questions is from the media—I saw the Nicolas Cage movie National Treasure a while ago. In the movie, Cage’s wife drives him crazy and almost to a divorce because she keeps asking him, “So?” Cage misunderstands her intentions and feels she is constantly pressuring and questioning him. They only manage to reconcile after they rebuild their mutual trust by undergoing a major adventure together and beginning to communicate properly.
The initial public offering (IPO) is when shares of a company are first sold to the public and subsequently traded on a public stock exchange. Newspapers are filled with stories about entrepreneurs such as the founders and initial staff of Google, eBay, or Alibaba who became billionaires overnight because of their IPOs. As a result, many aspiring entrepreneurs constantly talk about an IPO as their only end goal. It is worth noting that while IPOs can definitely be good things, they have their downsides. Often, there are other options besides IPO that should not be ignored.
IPOs can be glamorous and lucrative. This is because:
However, an IPO comes with certain downsides, too:
An IPO is important because it is one of the most common ways to exit (or “cash out”) of a new company. Exit is often necessary for a very practical reason. Many investment funds are not set up to own businesses in perpetuity. They have a defined, finite time horizon and they need to return the invested capital (hopefully, plus a profit) to the fund investors by the end of the agreed period. An IPO is only one way to exit or cash out. Another option is acquisition by another company. While it’s less glamorous, acquisition can often be even more attractive than an IPO:
Hence, IPO is not the only financial goal for start-ups and smaller companies. In fact, one of the highest profile start-ups in recent HBS history is Eachnet. Its organizers’ plan from day one was to copy eBay’s model for China. However, since China does not have a developed credit card system and the consumer sophistication found in the West, it was difficult for the company to have an efficient way to charge users and make money. But that was not an issue as the plan was never about making money from consumers. Of course, without a plan to actually make money, an IPO was not even an option. The key target was to sell to eBay. Eachnet’s founders bet on the expectation that eBay would find it an invaluable jump-start for the China market and eBay would have so much cash and tradable stocks from its U.S. IPO that it could acquire Eachnet at a very high price. Many investors considered it a very risky strategy and did not invest in Eachnet. But for the few who did, it paid off; they managed to make a significant amount of money when Eachnet was eventually sold to eBay.
Notes
1. Sundem Homgren and Elliot Prentice Hall, Introduction to Financial Accounting (Upper Saddle River, N.J.: Prentice Hall, 1998), 494.
2. Robert Knox and James Inkster, “Postdecision Dissonance at Post Time,” Journal of Personality and Social Psychology 8 (1968): 319–323.
3. Hal Arkes and Catherine Blumer, “The Psychology of Sunk Cost,” Organizational Behavior and Human Decision Process 35 (1985): 124–140; and Hal Arkes and Laura Hutzel, “The Role of Probability of Success Estimates in the Sunk Cost Effect,” Journal of Behavioural Decision Making 13(3) (2000): 295–306.
4. John S. Hammond, Ralph L. Keeney, and Howard Raiffa, “The Hidden Traps in Decision Making,” in Harvard Business Review on Decision Making (Boston: Harvard Business School Press, 2001), 153.