“Companies hit the skids for all sorts of reasons,” wrote Ram Charan and Jerry Useem in Fortune in May 2002, a time when a lot of companies were hitting the skids, “but it’s one thing that ultimately kills them: they run out of cash.” Entrepreneurs know this all too well. As Chip Conley, CEO of Joie de Vivre Hospitality, told us, probably the two most important measures for the entrepreneur who is just starting out are cash flow and burn rate (the amount of cash you burn through to operate in a given period, usually a month). Even in a more mature company, cash remains a critical variable.
In the big-company world, boards of directors and outside analysts sometimes focus too heavily on the income statement or the balance sheet. But even in this world there is one investor who watches cash closely: Warren Buffett. The reason? “He knows cash is hard to fudge.”1
Warren Buffett maybe the single greatest investor of all time. His company, Berkshire Hathaway, has invested in scores of companies and achieved astonishing results. From January 1994 to January 2006, Berkshire Hathaway’s Class A stock compiled an amazing compound annual growth rate of 15.1 percent; in other words, it rose an average of about 15 percent every year for ten years. How does Buffett do it? Many people have written books attempting to explain his investing philosophy and his analytical approach. But in our opinion it all boils down to just three simple precepts. First, he evaluates a business based on its long-term rather than its short-term prospects. Second, he always looks for businesses he understands. (This led him to avoid dot-com investments.) And third, when he examines financial statements, he places the greatest emphasis on a measure of cash flow that he calls owner earnings. Warren Buffett has taken financial intelligence to a whole new level, and his net worth reflects it. How interesting that, to him, cash is king.
Owner earnings is a measure of the company’s ability to generate cash over a period of time. We like to say it is the money an owner could take out of his business and spend, say, at the grocery store for his own benefit. Owner earnings is an important measure because it allows for the continuing capital expenditures that are necessary to maintain a healthy business. Profit and even operating cash flow measures do not. More about owner earnings in the toolbox at the end of this part.
Let’s look at that third element of the financial statements, cash, in more detail. Why target cash flow as a key measure of business performance? Why not just profit, as found on the income statement? Why not just a company’s assets or owners’ equity, as revealed by the balance sheet? We suspect Warren Buffett knows that the income statement and balance sheet, however useful, have all sorts of potential biases, a result of all the assumptions and estimates that are built into them. Cash is different. Look at a company’s cash flow statement, and you are indirectly peering into its bank account. Today, though the dot-com bust and the financial-fraud revelations of the late 1990s and early 2000s are several years in the past, cash flow is once again the darling of Wall Street. It has become a prominent measure by which analysts evaluate public companies. But Warren Buffett has been looking at cash all along because he knows that it’s the number least affected by the art of finance.
Entrepreneurs are like Warren Buffett, but it’s often more through necessity than through deep understanding. They are the ones who have to meet the payroll every week and pay the bills every month. They know that money in the bank is what counts. At a minimum they look at the checking account every week (and maybe every day) to determine whether there is enough cash to keep going.
But entrepreneurs may feel daunted when it comes to looking at a formal cash flow statement. For one thing, the language in the statement is a little arcane. Charan and Useem in their article were advocating a simple antidote to financial fraud: a “detailed, easily readable cash-flow report” required to be given to the board, to employees, and to investors. Unfortunately, no one, to our knowledge, has taken up the suggestion. So we are left with conventional cash flow statements. Most of these, however detailed, are hard for a nonfinancial person to read, let alone understand.
But talk about an investment that pays off: if you take the time to understand the cash flow statement, you can cut right through a lot of the smoke and mirrors created by your accountant or bookkeeper. You can see how good a job you and your company are doing at turning profit into cash. You can spot early-warning signs of trouble, and you will know how to manage so that cash flow is healthy. It isn’t enough just to look at your checkbook because you can’t always see the difference between different kinds of cash—cash from operations versus cash from the proceeds of a loan, for example. The cash flow statement shows these differences. Cash is a reality check on a business’s performance, and the cash flow statement reveals the reality.
One of us, Joe, learned about the importance of cash when he was a financial analyst at a small company early in his career. The company was struggling, and everyone knew it. One day the CFO and the controller were both out golfing and were unreachable. (This was in the days before everybody had a cell phone, which shows you how old Joe is.) The banker called the office and talked with the CEO. Evidently, the CEO didn’t like what he was hearing from the banker and felt he had better talk to someone in accounting or finance. So he passed the call to Joe. Joe learned from the banker that the company’s credit line was maxed out. “Given that tomorrow is payday,” the banker said, “we’re curious about what your plan is to cover payroll.” Thinking quickly (as always), Joe replied, “Um—can I call you back?” He then did some research and found that a big customer owed the company a good deal of money and that the check—really—was in the mail. He told the banker this, and the banker agreed to cover payroll, provided Joe brought the customer’s check to the bank the minute it arrived.
In fact, the check arrived that same day, but after the bank closed. So first thing the next morning, Joe drove to the bank, check in hand. He arrived a few minutes before the bank opened and noticed that a line had already formed. In fact, he saw that several employees from his company were already there, holding their paychecks. One of them accosted him and said, “So you figured it out too, huh?” “Figured what out?” Joe asked. The guy looked at him with something resembling pity. “Figured it out. We’ve been taking our paychecks to the bank every Friday first break we get. We cash ’em and then deposit the cash in our own banks. That way, we can make sure the checks don’t bounce—and if the bank won’t cash them, we can spend the rest of the day looking for a job.”
That was one day Joe’s financial intelligence took a big leap upward. He realized what Warren Buffett and experienced entrepreneurs already knew: cash keeps a company alive, and cash flow is a critical measure of its financial health. You need people to run the business—any business. You need a place of business, telephones, electricity, computers, supplies, and so on. And you can’t pay for all these things with profits because profits aren’t real money. Cash is.