Originally Posted by
Snoopy
The concept of analysing a company by looking at cashflow has a certain raw appeal. Profits are ultimately important. But a company can manipulate declared profits several ways:
1/ By classing a bad debt as collectible when it is not.
2/ By carrying goodwill on the books using optimistic future sales scenarios when those sales levels will be very difficult to achieve.
3/ By setting up bad debt provisions that allow the shifting of profits from one financial period to the next.
However, cashflow is 'day to day' important, because having a cash dividend deposited into your bank account is a gold standard kind of investment return that cannot be manipulated. Money in your bank account is tangible and spendable, contrasting with declared profits that amount to an indirect promise of a return of cash in the future.
I want to carry on with Winner's analogy and imagine you as a homeowner are running an in house business putting your tweenagers out to work selling lemonade at the end of the driveway, while simultaneously giving them free spending (pocket) money. Now tweenagers demand some pocket money, and generally use their accumulated (lack of) wisdom to make poor decisions and waste it, or use it on instant gratification. Nothing wrong with that, it is all part of the learning and budgeting experience. From a homeowners perspective, the pocket money paid out is analogous to a company paying dividends to shareholders. Once the pocket money is paid out, all control of what happens to it passes from the homeowner's hands.
To support the lemonade venture, our homeowner uses some leftover household cashflow, plus bumps up the mortgage to buy a brand new fridge. As well as being more efficient than the original fridge, it is much bigger to hold the vast litres of ice cool lemonade to satisfy the summer satiated pedestrians walking by the end of the driveway. Selling lemonade becomes a highly profitable home business for our homeowner. When discussing their finances, the homeowner could say:
1/ they borrowed money from the bank to pay the tweenagers pocket money (which doesn't sound too responsible) OR
2/ they could say money was borrowed from the bank to buy a new fridge to support the home business venture (which sounds much savvier).
But both of these explanations could be seen as correct though, depending on how an outside observer chooses to see the historic path, along which the homeowners cash was spent.
On the day cash is cash. Whether you give $500 out as pocket money, or put that $500 towards a new fridge, $500 cash will come out of the household bank account. However, no business person plans to invest $500, with a business plan to only recoup $500 from that investment. There has to be a profit at the end of the year. It is the new fridge that enables the selling of the lemonade and our little home business able to operate. After eight years, perhaps a new fridge will be required to allow the lemonade business to continue. Our hapless home owner may once again be forced to draw down the house mortgage to buy it. At this point the value of the original big fridge has been lost (cash value zero). But what hasn't been lost is the utility of using that old fridge over the preceding eight years. Yes the original big fridge capital has gone. But the cashflows from selling the lemonade over an eight year using that fridge were very real.
So what is the moral of this story? On the day, the negative cash effect of giving tweenagers pocket money OR spending that money on a new fridge is the same. But over time, the fridge delivered a positive cash return to our homeowner, while the pocket money simply disappeared (from our homeowners perspective). Thus although all cash starts out as being equal, over time it can end up not being equal. Or coming back out of the analogy, offsetting cash taken in over a one year period with cash spent on something that will produce a return over a multi year period is akin to subtracting apples from apples (from a snapshot perspective) but subtracting oranges from apples (from a multi year perspective).
SNOOPY