Hacker's Guide to Cashflow vs Profit

Had a wonderful time at Kingston Beta last night. 

There was a point brought up by one of the presenters that entrepreneurs should focus on cash-flow instead of profitability. There were a few questions and I don’t think that the questioners fully understood, so I figured it was time for a post to try and explain (if I am still not clear, let me know in the comments).


Cash Flow

Simply put the flow of cash in and out of your company. Cash can flow in from three sources: Operations, Investments, Financing. 

Operations - This is what your business does. If you are a doctor, your cash INFLOW from operations would be what your patients pay you (as well as health insurance companies), while your cash OUTFLOW from operations would be what you paid your secretary, the office supplies you bought at the store yesterday. If you sell books, your cash INFLOW is the cash that your customers pay you for the books. Likewise, your cash OUTFLOW is the cash you then hand over to the distributor that you got the books from that you sold + the expenses you had to pay (utilities, etc.).

Investments - Say your business is doing really well and you always have excess cash in your bank account every month after you have paid all your expenses, it is fiscally prudent to put that cash to work rather than letting it sit idle. Either by investing in your company (say opening a new branch, or buying new manufacturing facilities or new servers, etc.) or by investing in some security (buying government bonds, or stocks of publicly traded companies, etc.). The cash OUTFLOW is what happens when you spend the cash initially to make the investment. The cash INFLOW is what happens when your investment pays you (e.g. a stock that you own pays a dividend) or you sell that investment and get back cash. Most startups won’t do this though, because in the early stages of a company you can usually get a better bang for your buck by investing in your own company and growing it until you reach the point where you can get better returns elsewhere.

Financing - This usually involves raising money for your company. If you are startup, then that usually means that you are raising a round of Angel/Venture investment. Your cash INFLOW would be when they wire you the money. The OUTFLOW would only occur when the company is either sold, or you have enough cash to buy by the stock from an early investor/founder once you reach later stages. This is more and more common now, than it was a few years ago. From the Founder’s perspective, it is typically said the Founder is ‘taking money off the table’. Meaning, they are cashing out a small portion of their stock - the idea here is that it allows the founder to swing for the fences and go for a big IPO or a big acquisition without feeling like they will lose it all.


Profit is the amount of money you have received in income (typically from operations) that you have left over after you have paid (or accounted for) all expenses in any particular period.

However, this metric is fuzzy. Here is why.

Say you sell security software to enterprises. Each enterprise license is $5,000/mo. All customers have to buy in annual contracts, so each contract you sign is worth $60,000 USD, all things being equal. However, most enterprise contracts don’t pay you the entire $60,000 upfront. They might pay you $10,000 now, then another $10,000 every 2 months for the next 10 months. Or they might pay you $30,000 (half) now, and say they are going to pay you in 2 months. But in 2 months, they say they need another 2 months, and keep doing that for the entire year. In some cases you will eventually get the money, but there are the occasional cases where you don’t. If you don’t manage your cash flow you might incur expenses in anticipation of that revenue that might come too late or not at all.

That’s how companies go out of business.

For instance, say you sign up 10 of those contracts in month one. You feel happy. You just ‘made’ $600,000. If you bulk up and hire $600,000 worth of labour in month 1, to invest in product development and supporting this new contract, you could find yourself in a situation where you don’t have enough money to pay their salaries. If that happens you have at least three options a) lay them off - and face possible legal action depending on local labour laws, b) explaining the situation to your employees and asking them to forego pay - this too might expose you to legal action or c) getting more business to make up for the shortfall.

This is just month 1. Typically what leads companies to go out of business is this happens in too many consecutive months with too many clients and you get caught flat-footed or too underwater and can’t get a short-term loan to bridge you over until your customers pay.

That’s why, as a startup, it is fiscally prudent to focus on becoming cash flow positive - which basically means that every month you are taking in more cash than you are spending.

There are two obvious ways to do this:
  1. Increase your ability to collect from customers (i.e. increase the % of customers that actually hand over cash)
  2. Extend the time period you have to pay your bills. For some things it’s harder (e.g. utilities, wages, etc.), but there are some things that you buy that you can usually get a break on - that give you another 30 - 60 days to pay.

Once you understand these concepts, you can then understand why companies like Twitter, Facebook and GroupOn work the way they do.

Very briefly, here are some thoughts on the way these concepts affect those companies - without me having any internal knowledge of them, just speculating based on what is available in the public domain.

Twitter - The most famous thing to be said about Twitter is that they are not making any money. So let’s assume that they are actually not earning any money (even though that’s clearly not true from the Promoted Tweets and other advertising we see creeping into Twitter slowly but surely), the way they stay alive is by continually raising rounds of financing. According to Crunchbase they have raised about $1.16B to date, in 8 different rounds of financing. So they can use the money from investors to pay their monthly bills while they figure out how to make money.

Facebook - While on the surface looks similar to Twitter, with $2.34B raised in 11 rounds, in 2009 they announced that they were cash-flow positive (meaning they took in more cash every month than they spent). That doesn’t mean that they are profitable, but that definitely is a great sign. It indicates that they can continue growing and are in no immediate threat of going bankrupt.

GroupOn - They too raised many rounds ($1.14B over 6 rounds, according to Crunchbase as a matter of fact), but they have been famously not-profitable. They have also been expanding rapidly - in January 2011 they were at 4500 employees up from 3000+ in November the year before. So how have they been able to keep up that dizzying pace of growth? Not just venture financing….it’s also how they treat their revenue. What they do is collect the total amount of the coupon (say $50 for $500 worth of pink high heels??), then they pay out say 50% of the $50, so $25 to the store at some point in the future. The longer they can hold on to that $25 that they have for the store, is the more things they can do with it. 

So while most companies do try to extend the amount of time they have to pay their vendors, GroupOn seems to have it baked into their revenue model. 

In my humble opinion, that’s not sustainable and that’s just one of the many reasons that investors have been crying foul over GroupOn’s filings.

One last example of a company that is ‘highly profitable’ but can go bankrupt from lack of cash is what we saw happened with GE in the middle of the credit crisis. GE made about $12B in profit in 2010, on revenues of $150B. However, a big portion of the stuff they sell (airplane engines, locomotive parts, MRI machines, etc.) are very expensive. So they extend a line of credit to their customers. So even though they have booked an accounting ‘profit’, they don’t collect the cash from their customers very frequently for those sales. What they do is go to the investing public and sell investing products very frequently. To see all the ways you can ‘invest’ in GE check out this, thisthis and this. As a matter of fact, while I was doing research for this post, I learned something I never knew before….apparently GE issues commercial paper in 1-day increments. That means, they will borrow money from you for 1-day and pay you back the next day - with interest of course, but there is a catch. 

Range of Maturities

Commercial Paper is generally offered from 1 to 270 days.

Minimum Investment Amount

The minimum is $100,000 for transactions with a term of seven days or more. For transactions with a term of one to six days, the minimum amount is $500,000.

That completely blows my mind. I am used to seeing 1-year, 10-year and 30-year maturities on bonds. But 1 day? WOW! That really shows you that they need the cash every day just to keep going.

So in the middle of the crisis, when they could no longer borrow for 1-day, they ran out of cash (literally overnight). They had to apply to the US gov’t for a temporary life-line.

If they didn’t get that, large sections of the company would have been in trouble (if not the entire company).

So that’s why it is better advised to focus on becoming cash-flow positive and not ‘just’ profitability. 

I hope that helps with any confusion around this topic.

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