Cash Flow or Profit Growth?
Jan 23, 2009

“If you look after your cash flow, the profits will look after themselves.”

One of my bosses had given me this sermon when I was just a management trainee. Though I didn’t quite agree with him then, over the years I have realised the wisdom of those words. The unfortunate part is that the reverse is not true. If you try to look after just profits and neglect cash flow, the business will surely be destined for doomsday, like many we are seeing these days.

What is Profit?

It is said that “Profit is an agreed amount arrived at on the basis of considered opinions of senior accountants” – this is a quote from another of my ex-bosses, a marketing man, but of great financial wisdom. That’s true actually – profit in a Profit and Loss Account is just a matter of opinion, an accounting concept – it is not a hard real number. Of course, when senior accountants give their opinions, they follow some principles, parameters and GAAPs (no pun intended) – like consistency of accounting policies, going concern basis, reasonableness of estimates, assumptions etc etc. But in the end, it remains an opinion. You change the accounting method and profits will change. Many Indian firms following Indian GAAP (Generally Accepted Accounting Principles), will have their P&L and Balance Sheets completely rewritten, often becoming loss-making units instead of profitable ones or vice versa, when they change to a different accounting standard like IFRS or US GAAP.

Cash Flow

On the other hand, Cash flow is real. You can physically count the cash, if you wish to, at the end of every accounting period – or get your banker to vouch for the cash in your bank account. If you make large profits, but fail to realise that in cash – that is, fail to collect your dues from the customers – your profits will remain book profits only and the business will suffer from cash crunch, leading ultimately to decline, unless the situation is corrected in time.

You would also see easily that while it is possible to make quick adjustments to profit figures by accounting means at the year end, say by invoicing large quantities of goods on the last day, Operational Cash Flows are not susceptible to such accounting entries.

Cash Flow Based Decision Making

I would strongly advise everybody to go for cash flow based parameters (not just profit based) for all business planning, decision making, target setting and incentive plans.

All investment decisions must be based on operational cash surplus/deficit generated and the discounted net present value thereof. Whether you are valuing a business for acquisition or for disposal, whether you are making capital expenditure to increase capacity or to improve efficiencies, whether you are trading in the stock market – if you are not using cash flow methods, you are inviting trouble for yourself and your business.

Cash Flow Based Planning

While investment decisions based on NPV (Net Present Value) of cash flows are not uncommon, I have hardly seen any business plan or a system of budgeting, where cash flows are an integrated part of the planning process. Similarly it is very unusual to find a KRA (Key Result Areas) system where cash flows are made an integral part for deciding on targets and incentive system for rewarding performance. Unless you get the entire organisation to think “cash flow” rather than “profit”, Operational Cash Flow based management practice will remain ineffective.

Are we chasing the wrong targets ?

Are we chasing the wrong target when we go after profit growth? Isnt it just a red herring ? Doesnt it make more sense, especially in the current context of global economic down turn, to focus on cash generation and cash preservation and move towards a cash flow based management system rather than go after a theoretical concept like Profit ? 

If only the (in)famous investment bankers followed a simple cash flow approach to business, rather than sexy valuation models for accounting for derivatives, may be ….well, may be, we could have avoided this downturn itself.

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6 Responses

  1. Sada

    My observations/Comments are:
    a) How about bringing in the flavour of combining both Profit and cash flow as true health indicators?
    b) Is it possible to give some examples of how this will work
    c) What’s the next topic?

  2. Hello Sada,

    Yes you are right – a combination of Cash Flow and Profit (please note that I put cash flow first) would be a good option. But it is possible to eliminate profit and replace it with Adjusted Free Cash Flow in all profitability indicators.
    I will write a post next week elaborating on this and with examples of course.
    Well – for my next topic, please check on Tuesday 27th.
    Ujjal

  3. That is content! Good start, and I am sure you will be making some impact on the lives of us mere mortals, specially with your financial expertise. Look forward to the next post.

  4. Irene

    your observations on cash flow or profit growth
    is thought provoking even for a non finance person like me.
    I have read your views a couple of times and have managed to get the essence of it.
    you have established that chasing just profit growth is red herring, that is something that distracts you from the real goal.Have I got it right?
    for me its quite radical and thus interesting!

  5. Yes. Thats right. If a business chases cash flow and cash generation, the profits will automatically happen – you wont need to chase and search for profits, unlike what most of us do all the time.

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