This is a summary of a great š³ tree book on the basics of business. This book is rather unusual because it acts as a condensed guide on business for employees looking to advance in their careers. Regardless, because it is not a long book, I recommend that you buy it for reference. Read more about book classifications here.
Great write up, @cedric ! Based on this summary, I bought and devoured this book in a couple days and I have to say - it was well-worth the praise you gave it. In particular, the discussions on cash generation and the relation of ROIC, margin, and velocity were fantastic.
One question I had from this piece was the following quote:
(Conversely, companies can delay turning a profit if they have good cash generation. An exercise for the reader: how is it possible to run a company at an accounting loss with positive cash flow? What does this mean in terms of a business playbook?)
I thought about this for a bit and I think I understand on a month-to-month basis how this would work. For a simple example, letās say Iām a factory creating and selling widgets. I have to make payroll bi-weekly and pay for electricity every month, but somehow I get my suppliers to agree to only request payment for the supplies at the end of each year.
Letās say I sell more than enough widgets to cover payroll and electricity/maintenance for the factory, but that the total sum of cashflows after salaries and factory electricity/maintenance is not enough to cover the cost of supplies, even assuming I donāt invest the surplus cashflow in new projects and instead sit on it to pay the suppliers. So when the end of the year rolls around, Iām basically left with only one choice, right? That is, find a way to raise capital.
Is this an accurate portrayal, or am I missing something? It seems from this thought process that any cashflow-positive business showing an accounting loss will, at some point, need to raise outside capital in order to pay off the accounts payable items that are generating that accounting loss.
EDIT: Having thought about this a little more, assuming that my previous reasoning is correct, I think an interesting corollary is that in order to escape this āaccounting loss with positive cashflowā situation, your ROIC must be higher than your cost of capital. Using the previous example, if that is the case, then you can use the positive cash flow to finance expansions and take out debt at the end of the year to address any accounting shortfalls. Since your ROIC is greater than your cost of capital, eventually your returns will grow to outstrip costs and your accounting loss will flip to a profit.
Iām still not completely sold on my own reasoning here, so please feel free to poke holes!
Well, one example is what John Malone did (which I covered in The Games People Play With Cash Flow).
An additional example is linked to in the blog comments for that Cash Flow article here.
Basically, Airbnb collects payments for bookings up front (you pay, as a guest, using your credit card), and then Airbnb pays out to hosts in the future, after your stay. This cash may be used to fund operations. You can see how ā so long as people continue to book on Airbnb ā the cash from future bookings can continue to be used to pay salaries and other business expenses today, even if the company doesnāt show an accounting profit. This is a fantastic situation to be in, and explains why Airbnb did not have to raise that much money as it expanded.
This is known as a negative cash conversion cycle. Amazon also had this cycle, as we explain in the Amazon Scale Economies case.
The flip side of that is if people suddenly stop booking on Airbnb, the company would be in dire straits almost immediately. This is what happened during the pandemic. Airbnb was forced to raise emergency financing, with an incredibly high cost of capital, in order to refund all guests and to keep the company afloat. This is why today, Airbnb does not charge you for your stay up-front. (Or at least, it doesnāt charge the full amount).
Thank you for the links @cedric! These were very helpful. I guess the concept Iām struggling to wrap my head around at the moment is the following: if your company is showing an accounting loss, wonāt you necessarily run out of money without an injection of outside capital, given a long enough time scale?
Maybe Iām missing something, but it seems to me that if youāre showing a loss, at some point you wonāt be able to sustain it despite the favorable cash conversion cycle.
Actually, as Iām typing this out, I guess I see how it could be possible over a long-ish timescale. Letās assume that I make $x in revenue from a product that cost $(x+1000) to buy, so Iām showing an accounting loss. But I donāt need to pay the supplier for 90 days. In those intervening 90 days, maybe I invest in some areas of the business that allow me to reach more customers (a la Amazon growing distribution centers), so this time I ask for a shipment of $(x+5000) worth of goods and sell it for $(x+4000). Again, Iāve shown a loss, but I can now use that $(x+4000) in revenue to pay off the original $(x+1000) shipment of goods, so the negative cash conversion cycle enables me to keep running at a loss, provided that Iām growing.
So I guess this chain of thought opens up a second question - is the only way to avoid paying the piper when youāre showing an accounting loss with a negative cash conversion cycle to either grow indefinitely or raise capital?
Ding ding ding!
Thatās exactly it!
Thereās a variation of this game that John Malone played, where he used depreciation of TCIās cable assets as a tax shield to shelter cash flows that could be used to grow the business, showing an accounting loss for 25 years, right up to the point where he sold to AT&T. In this case he maintained a reasonable (and disciplined!) amount of debt, had extremely predictable cash flows due to the monopoly TCI had from its government granted cable rights, and was buoyed by a cable market that grew continuously for four decades. (1960s ā 2000s)
Four decades is not āindefinitelyā, but it is a heck of a long time. Long enough to raise a child to middle-age. Long enough for a full career.
Awesome, thank you @cedric ! This conversation was super helpful for solidifying my understanding here. I just picked up a copy of Cable Cowboy as well thanks to all the talk of John Malone with regards to cash flows - looking forward to diving in to learn more about his strategy!
As an aside, Iāve been working through Value by Tim Koller, Richard Dobbs, and Bill Huyett over the last week or so, and Iāve found it to be absolutely fantastic for explaining the links between cash flow, growth, and ROIC. Super approachable book with a lot of great nuggets of insight. Iāll almost definitely be diving into their heaftier Valuation book after this one.