Peter Thiel, founder and former CEO of PayPal and famous venture capitalist starts his book by asking:

“What important truth do very few people agree with you on?”

Peter Thiel, Zero to One

This is a difficult question because you need to have a confident and contrarian opinion to what the masses have. I don’t know if I know of such a truth. But here is one that I have been thinking in my head and that is: the Cash Flow Statement is far more important than the PnL statement.

You may wonder- that’s it? Of all the truths in the world, I had to pick some random truth like that? I have a friend who is a Chartered Accountant and when I discussed this with him, his strong opinion was that the PnL is and will be the most important one. Investors, not just stock investors, but large funds and VCs pay a lot of attention to the PnL and therefore PnL will remain the king. If large institutional investors with their army of researchers strongly believe in something, then we must have guards up. The large institutions may believe in it, because that is what other large institutions believe in. Surely, if everyone believes something, it can’t be wrong? Just like, before Copernicus, everyone believed that the sun revolved around the earth. And sometime before everyone believed that the earth was flat.

So this would be my simple and humble answer to Peter Thiel: cash is the reality for any business and therefore the Cash Flow Statement should be analyzed in more detail. Even more than the PnL.

I was to present on this topic at Flame University but they cancelled the program. And therefore I shall subject my readers to not one but a series of blogs on the importance of cash and cash flow statement. This is just the first.

Do note: I am not an accountant and I don’t pretend to be one. I also like things laid out in simple form for me. If you are like me, you will find the CFS easy to understand and insightful.

—

A business does not go bankrupt because it makes losses. A business goes bankrupt when it runs out of money. Even a profitable business can go bankrupt if it runs out money, while a loss making business may never go bankrupt if it never runs out of money.

Therefore worth repeating: a business goes bankrupt when it runs out of money.

Yes- Profits and Losses were supposed to be the metrics which told us whether a company has money or not. But because the Accounting Standards are so complicated, Profit and Loss don’t present the real picture. To me, Profit and Loss are reduced to accounting concepts and don’t present the reality.

So where do we go for the real picture? To the Cash Flow Statement (CFS).

The CFS shows the movement of actual cash. So you can see how much cash is coming in vs how much is going out. And how much is going towards say growth, towards acquisitions, towards debt reduction etc. In short, to know a business, follow it’s money trail – the CFS.

The CFS is underfollowed, under analyzed and even underutilized. Therefore, you and I can build our edge by doing the opposite- analyzing and building insights using the CFS.

Why does the CFS deserve your attention?

Reason 1: Sales is vanity. Profit is sanity. But…cash is reality.

Think of all those unicorns, soonicorns that were growing like crazy just a couple of years ago. And now many are struggling. Why did that happen? My guess is, they were growing using easy money provided by investors while the core business itself wasn’t generating enough cash. So when the easy money went away, the businesses and their investors realized a painful truth: Sales is vanity, Profit is sanity but Cash is reality. Kind of like what Buffett said: It’s only when the tide goes out, you realize who has been swimming naked. And all the naked swimmers are running for cover now.

You see, you may be growing sales like crazy, you may even have profits on paper. But to pay your Bankers you need cash. To pay your suppliers, you need cash. To pay your employees you need cash. To pay your taxes, well you need cash for that too. So it all comes down to this: do you have cash or not?

Let me illustrate this further with two examples.

Example 1:

A true story. In 2019, a friend came to me. He had invested some money in a start up that supplies to office pantries…you know they make sure your office pantry has enough coffee, tea, milk, sugar, water etc. He said that these guys were good, honest, young men and they were rapidly growing their business. He said there is only one problem: they keep asking for more and more money. So, I offered to look into it. (If somebody thinks I am smart…that’s 10 minutes of warmth I can enjoy.)

So I looked into the cash flow statement. It turns out that this start up didn’t own the trucks or the warehouses. They had leased it all, because they didn’t want to invest capital in those assets, just yet. They were buying supplies and distributing them to their client offices. Their clients were large MNCs and they were paying them after 45 days whereas their own suppliers who were big and powerful were demanding payments within 18 days. No payment- no trucks, no warehouses and no supplies and therefore no future business. (Remember, I said businesses go bankrupt when they run out of cash?)

So, it’s like: I make a sale, I get paid after 45 days. But in the interim I need to make payments to my own suppliers every 18 days or pay them 2.5 times before I get paid once.

And to make matters worse, they were growing at 6% month on month. That means they were doubling their business ever year which means that the quantum gap between what-I am-owed vs what-I-owe becomes larger and larger with each passing month. No wonder then that they keep asking for more money from their investors. Simply put:

• Is the business growing? Yes.
• Is the business profitable? Yes
• Does the business generate cash? No.

And because the business does not generate cash, it needs to depend on the kindness of others for cash- either investors or bankers. I wouldn’t invest in such a business.

Example 2:

Now, imagine another business where you get paid upfront. For example – you pay your Insurance Premium upfront. You pay your landlord upfront. You pay for your Royal Enfield upfront. For these businesses, there is no dearth of cash because the cash comes in before the expenses go out.

Royal Enfield gets paid something like 15 to 20 days upfront and pays its own suppliers after some 30 days of the sale. So, there is a 45-day period (-15th day to +30th day) when it gets to hold other people’s money (customers’ + suppliers’). So it gets paid some 2 times before it needs to pay it’s suppliers. An opposite scenario of the startup. Here the reality is that both customers and vendors need Royal Enfield more. And the bigger it gets, the more it’s gets other people’s monies.

Now, this is the kind of business I’d be interested in because you aren’t dependent on others.

—

So let me summarize this first blog by saying, Cash is reality. Therefore if you really want to know how good a business is, go to the CFS.

—

Thank you for reading. This is the first blog in a series. The second and third blogs are here and here respectively.