Everyone looks at profit and their bank account first,
but what if I were to tell you were doing it wrong?
Today I break down cash flow and a new way to calculate capital expenditures.
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The ultimate cash flow metric
One of the hardest concepts for non-accounting (and even many accounting) people to understand has been that cash is not the same as profit.
Businesses chase profit without the realization that profit does not equal cash.
Let me explain.
Say you buy $100 of inventory of Widget A.
This $100 has to be paid immediately.
You then sell $50 of inventory for $155.
In Accrual basis financials, you now show a profit of $105.
But the $155 was SOLD, not paid for.
That means you are still out $100, but now have a promise to pay $155.
Now say someone buys $45 of the $50 remaining dollars of inventory for $140.
Again, you have a promise of $140 more, but are still out $100.
But you are now OUT of inventory. To buy more inventory you need either cash or terms.
If you have neither, you can no longer sell any more product (unless you pre-sale future inventory).
I go deeper on this in this post, if you’re interested in understanding the mechanics of cash flow.
More than profit
So, while profit is great, it’s only a small part of the picture.
Profit has to be high enough (and ultimately cash collected on that profit) for you to be able to:
- Purchase inventory to support growth
- Allow for reinvestment into the company
- Pay dividends to owners
If you business isn’t creating enough cash to support the growth of the operation or allow for reinvestment, your business can be profitable but structurally insolvent.
This means you have the inability to pay for your expenses and debt, which is one step away from bankruptcy.
So, in reality, there are 2 numbers we care deeply about, which tell us our ability to reinvest and support growth:
- Operating Cash Flow
- Free Cash Flow
You will find Operating Cash Flow on the Statement of Cash Flows. It is:
Free Cash Flow is just Operating Cash Flow minus Capital Expenditures.
What are Capital Expenditures you might ask?
These are purchases of long-term assets.
For some businesses, like service businesses, these are non-existent.
For others, like manufacturing facilities, these require huge long-term plans.
But not all CapEx is equal. There are two distinct types of capital expenditures:
- Maintenance
- Growth/Expansion
Types of CapEx
Warren Buffett coined the term years ago “Owner’s Earnings,” where he takes into account only maintenance capex to determine if a business is able to continue on in its current state.
I’m not a huge fan of Buffett’s calculation, as it doesn’t account for Balance Sheet cash changes (which really matter to small businesses), but the concept of splitting maintenance versus growth capital expenditures is right on point.
Say I’m a service business that requires $100,000 of equipment to be purchased every 4 years. Once you’ve purchased the equipment, your revenue is dependent on that equipment working to continue operations.
If the equipment stops working, you’re unable to complete your work. Employees sit still and revenue quits getting generated.
Of course, you need to replace the equipment. Without it, you’re unable to continue operations.
This is maintenance CapEX. It’s REQUIRED to keep operations running at the same level.
But, say your team wants to upgrade equipment or buy equipment that allows you to provide more services.
Not upgrading or buying wouldn’t mean revenue would go down, just that you’ve put an upper limit on what revenue could be.
This is growth CapEx.
If you’re struggling to hire people and your team is already overworked, not getting the CapEx might be the right decision. You couldn’t fully utilize it even if you had it.
But if you don’t have the cash flow, no matter the situation with hiring, you wouldn’t be able to even consider this proposal.
When you generate just enough cash to cover maintenance capex, but no more, you can’t jump on growth opportunities that might arise.
A new calculation
Operating Cash Flow and Free Cash Flow are great measures.
But if you have significant CapEx, the difference between maintenance and growth CapEx is hidden between these numbers.
The real questions we need to understand are this:
- Am I making enough money to continue operations at the same level?
- How much am I generating in excess of maintenance… thus how long will it take to afford growth CapEx?
To help us identify this, I’ve coined my own formula and term “Maintenance Cash Flow.”
Here is what the calculation looks like:
When looking at the calculation this way, it allows you to evaluate them separately, as they’re 2 different types of spend.
Growth CapEx is essentially an R&D CapEx where, yes, you want a specific return. But that return is more risky and less guaranteed.
With Maintenance CapEx, it’s the business's job to manage their ability to address the maintenance needs without hurting ongoing operations.
Failure to plan for and hold back enough cash for Maintenance CapEx could be an extinction event for your business.
Service Businesses
For service businesses, think about this in terms of people CapEx. To scale, you typically need to hire more people.
Ask: to pay for this person and keep our margins, how much in additional sales would I need to make?
Much of this depends on:
- The work you have
- Your ability to get them up to speed
- Their ability to adapt to new procedures
When you have the work and can get new hires up to speed quickly, your only limiting factor becomes the contracts you’re able to procure.
What do you do with Free Cash Flow?
Once we’ve gotten to the Free Cash Flow number, we have to ask, what do we do with this money?
Next week I’ll talk about another level to the calculation called “set-aside.”
This is how much money we need to set aside to pay for future Maintenance and Growth CapEx.
The result after “set-aside” is Available Owner’s Distributions.
We’ll talk about this, and how to calculate Maintenance & Growth CapEx needs next week.
Something Interesting
Only one link this week!
Last weekend was the Berkshire Hathaway shareholder’s meeting, which means a bunch of nerds took a pilgrimage to Omaha, Nebraska to take a picture of a large arena.
In the midst of that, I read an article about how Buffett only needs to make one good decision every five years to be successful.
I have a lot of thoughts, which I’ll probably write about in the future, but it’s a great reminder: we make a lot of decisions in life, but a select few determine our overall trajectory.
Get good at making those few and you’ll have a successful life.
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See you next week,
-Kurtis
