Do You Have Proof That Cash Flow Is Better Than Earnings?

This is an updated post based on a video answer I did to the above Quora question. Is cash flow better than earnings?

To see that video you can go here.

I’m updating and expanding on the content in that video to better illustrate to you why cash flow is better than earnings.

I hope you enjoy.

Jason.

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I saw this asked on question and answer site Quora and took that as a little bit of a challenge to think about it.

Because to me, cash flow is one of the most important numbers I look at along with operating margin and return on invested capital or (ROIC).

While regular earnings or net income is almost completely useless to me.

Today, I’m answering the question above to show you why I think this way.

Contrasting Scenarios

To better answer the question for you, I’m going to do with a made-up scenario involving two (2) companies.

Company One (1) has a net income of $1 million dollars. Net earnings are also called net income and net profits as well.

This company must put 100% of its net income back into the business, every year – just to sustain the business. It must replace and upgrade equipment, buy new equipment, etc.

Every year, all their net income goes towards sustaining the business and buying equipment.

This means 100% of the value of the company is sitting there in its equipment. And the company has zero cash flow.

The only way this company can earn higher profits is to use this equipment, as much as, possible before maintenance and repair costs make that unfeasible.

And then they must repeat the process of buying more new equipment.

This leads to several problems for the company

First, the company must do this. If it stops buying and repairing equipment to do jobs, the business dies.

It has zero cash flow left over to do things, like hiring new people, and expanding operations.

The only way it can expand is to buy more equipment.  But, in the short term, this lowers its net profit earnings even further.

This scenario also leads to more repairs and having to buy new equipment more often due to heavy use. This would likely keep the company’s net profits in this same range forever. No matter how high revenue grows.

This also prevents the company from expanding geographically.

In other words, Company One (1) is tied to the almost constant usage of its equipment to generate net income.

This also means that Company One (1) is just sustaining its business. It’s not growing the business; It’s just maintaining the business, at its current level, by using 100% of its capital.

No Margin of Safety

If a company must do this, it becomes unsafe. Why?

Let’s say a piece of equipment breaks down, but it is still under warranty.

You’ll get your money back, or you get a new piece of equipment, whatever. But it takes three (3) months to replace the equipment.  

Nevertheless, the company has other expenses like payroll.

The side of the business that is operating comes to a halt. This leads to zero income and zero revenue for the entire business in three months. Still, the company waits for the replacement or machine to be fixed.

To keep the business running, at the same pace, the company would likely have to take on debt at bad terms, or issue equity at unfavorable terms, just to keep the business running and retain employees.

If something bad happens like this, the company is in trouble.

If it decides not to do this, the business may die, or the company will have to lay off a lot of people.

This is like what we are seeing now with the coronavirus situation.

To put it bluntly…

There’s no margin of safety

This kind of company has zero real-world profits. As in money that can be used to grow, expand, invest, etc.

There’s zero margin of safety and the company is just sustaining itself. It’s not growing.

It’s likely fulfilling a valuable service for itself and its community but it’s not making any money in a real-world sense and there is zero margin of safety.

This doesn’t sound like a great business does it? But this is how most businesses worldwide operate. With zero real-world profits and zero margins of safety because they focus on net income earnings instead of cash flow.

Company Two (2), on the other hand, works in the same industry with a net income of the same $1 million, but, because of the efficiencies they’ve created within the business, it only has to use 80 percent of their net income for capital expenditures to sustain the business.

In other words, they have 20% of net income left over every year – or $200,000,00 – every year to reinvest in the business.

This is cash flow

This could mean hiring more people, working to create more efficiencies, doing better and more marketing, expanding geographically, buying more equipment, whatever.

Not only does this give the company more options like those mentioned above, but it also makes them safer as an investment because they have room for error.

This 20% extra in cash left over, every year also gives them a ton of options than just the ones above…

They can put this capital towards growing their profit margins even further, work toward growing market share, work toward becoming even more efficient and cutting costs, etc.

And that still isn’t all…

If the company invests this excess $200,000 in capital, every year, at a rate of 10% per year, the company will increase its net profit margin substantially over the next 10 years.

By a total of 159% within 10 years to $518,749 as seen below.

This means that not only would the company earn more every year. But that all else remaining equal, the underlying value of the company would go up about 159% in this time as well.

After 10 years Company 1’s stock would be worth an estimated $5 and $10 million.

After 10 years Company 2’s stock would be worth an estimated $15 and $25 million due to the increased profitability of the company.

How do you evaluate this?

You can find this kind of information by looking at the company’s 3 financial statements – Income Statement, Balance Sheet, and Statement of Cash Flows.

Net income is on the income statement.

If you’re on Morningstar go to the stocks financials tab and scroll down the page until you see the following…

This is net income. From here its brought to the top of the cash flow statement as shown below.

The income statement ends with net income and the cash flow statement begins with net income.

After you bring net income over to the cash flow statement, then you add and subtract things, like depreciation and amortization, stock-based compensations, investment income, proceeds from sales of shares or issuances of debt, spending on capital expenditures, etc. from there.

Scroll down the statement of cash flows, until you either see free cash flow or what’s shown in the following example taken from Morningstar’s new cash flow statement page.

This is free cash flow for a company

Now let’s get back to our 2 companies as an example…

Company Two (2) is the far better investment in this case, all things remaining equal.

But there’s still more…

I talked about this a bit above, but I want to reiterate it here…

If issues come up at Company  One (1), it will have to put off buying equipment which will lower revenue and profitability. And it’ll have to issue debt or equity at unfavorable terms just to stay alive.

If it must do any of the above these will further decrease the value of the company by further lowering its profits, margin of safety and value.

If an issue comes up with Company Two (2) – it will have cash on hand, it can use to repair the part or equipment fast.

It won’t lose business. It won’t have to issue debt or equity at unfavorable terms. Plus, it can still use any excess cash left over after paying for the part or repair to keep growing the company.

Not only will Company Two (2) increase its value over time by earning more and more cash. But it also has a larger margin of safety, in case, any kind of issue does come up.

Issues always do come up in business

Does this explanation of earnings vs cash flow 100% confirm that cash is better than earnings?

To me it does.

Plus, this is a simplified explanation that doesn’t even deal with things like how cash is far harder to manipulate than net profit earnings.

Five years ago, I started talking to more private business owners and almost zero of them have a cash flow statement they use in their day to day business.

Almost 100 % of business owners I’ve talked with focus on the P & L statement or income statement.

To me, you should spend 90 to 95% of your time analyzing the balance sheet and statement of cash flows. And only a small minority of time on the income statement for the various reasons mentioned above.

And almost zero private business owners even have access to a reliable cash flow statement.

In other words

Most private businesses do things backward from what they should be doing.

The income statement doesn’t even account for capital expenditures which almost every business on Earth has.

This is another reason, it is far worse than the statement of cash flows.

If I ask a private business owner – and I always do – if they can give me their income statement and balance sheet they have no issues.

But if I ask them for their cash flow statements, they look at me and ask why.

I get it. Most people focus on earnings for two (2) reasons.

• A.) It is easy to access.
• B.) Earnings are reported everywhere on any financial site you ever look at.

Private business owners take their cues from public company stocks, so this is why they focus on earnings.

Earnings are easy to find, while cash flow is harder to find and figure out.

But cash flow is one of the most important numbers to look at.

It’s an indicator of the real-world profits a company earns. Not just profits on paper like net income earnings.

And I hope this showed you the same.

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