by Kevin Rabida . November 5th, 2014
There seems to be a greater emphasis on revenue and profit numbers in analyzing business performance or making business decisions that we sometimes neglect a critical variable: cash flow.
Granted, these three are important factors (among a dozen others) to consider in evaluating the general health of a company. But for startups, cash flow is astronomically more critical than revenue or profitability.
For the uninitiated who didn’t take up accounting 101, or the lazy who didn’t listen while this was being discussed (I sure as heck didn’t), revenue, profit and cash flow are essential accounting terms.
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Investopedia defines them as follows:
Revenue is the amount of money that a company actually receives during a specific period, including discounts and deductions for returned merchandise. It is the “top line” or “gross income” figure from which costs are subtracted to determine net income.
It is calculated by multiplying the price at which goods or services are sold by the number of units or amount sold.
Profit is the financial benefit that is realized when the amount of revenue gained from a business activity exceeds the expenses, costs and taxes needed to sustain the activity. Any profit that is gained goes to the business’s owners, who may or may not decide to spend it on the business.
It is calculated by subtracting total expenses to total revenue.
Cash Flow is a revenue or expense stream that changes a cash account over a given period. Cash inflows usually arise from one of three activities – financing, operations or investing – although this also occurs as a result of donations or gifts in the case of personal finance. Cash outflows result from expenses or investments.
Still with me? Great! Now that we got that out of the way, let’s discuss the problem.
Revenue is the most mentioned and emphasized variable when discussing business and for a good reason. It is predictable and to some extent, stable. Say you have 100 headphones that you sell for $100 dollars each. After selling them, you would have $10 000 revenue. Easy enough.
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Revenue is also a good way to measure your business relative to other businesses in your industry. It is an indicator of demand and a factor in determining your business’ market share. Generally, higher revenue means stronger company.
But the problem with revenue is the overemphasis on it. You may boast that you have $10 000 revenue from your headphones business relative to the $5 000 average revenue of your competitors. But what if you buy them at $9 990 from your supplier compared to the $4 000 of your competitors?
If you factor in further your other expenses such as salaries and utilities, your revenue would likely be negative. You lose money every time a customer buys your headphones. We don’t want that. Focusing on revenue numbers without context could result in business failure.
Just like revenue, profit is a choice indicator in business performance. Say your expenses in a period totaled $7 000. Subtracting that from your $10 000 headphones revenue, you would get $3 000 profit.
However, you can be unprofitable but would still succeed. And you can be a profitable business but would still fail.
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The first few years of a business are generally unprofitable. This results from investing towards the growth of business such as buying equipment and other assets, acquiring people, or marketing the product. But that doesn’t signal failure.
From the example before, say you sold 10 of your headphones on credit receivable next year. Your business would report the same profit of $3 000, but the cash inflow required to cover the expenses would be available next year. Your creditors need it now. What more, it turns out that your debtor cannot pay after being bankrupt. Fail.
Don’t get me wrong. I’m not for the complete disregard of revenue and profit. I just want to emphasize the importance of cash flow, especially for startups. Cash is what you invest for growth. Cash is what you pay your debtors. Cash is what pays the bills.
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Cash Flow can be broken down into two kinds: Operating Cash Flow (OCF) and Free Cash Flow (FCF).
OCF is the amount of cash generated by your normal business operations. This is what banks usually look to decide if they would lend you credit. Businesses with good OCF aren’t likely to go bankrupt, and thus, would be able to pay their debts.
FCF is the amount of cash flow after subtracting capital expenditures from OCF. An expense is considered a capital expenditure if it’s an acquisition of new asset or an improvement on an existing asset, that is, a reinvestment to the company. It is, in essence, the “real” cash a company generates and a critical indicator for business success.
This post wasn’t meant to downplay the importance of revenue and profit. They are, and would always be, essential for business. For startups, however, revenue and profit are important in the long term, but before that, you must focus on survival. And that requires careful cash flow projection and planning.
I understand that this might be a heavy read, but knowing these things can be the difference between success and bankruptcy. Then again, you could always hire an accountant.
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Do you have any comments with my thoughts on revenue, profit, and cash flow? Post your comments below!
Kevin is a reader first, a writer second, and a gamer somewhere in between. When not rooting for Tyrion Lannister for the Iron Throne, he's probably writing some morbid short story. He enjoys some surreal art, clever advertising campaigns, and a warm cup of coffee while reading Murakami.