Breaking the break-even barrier for cash flow

It is clear that the most important cash flow is from operations, as it tells you if the business is covering its cash from its core business.

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This column recently covered the challenges of managing negative cash flows. Breaking through the cash flow break-even barrier is a completely different matter. Start-ups seem to reach this point and never leave it, a gravitational black hole. Understanding this statistical anomaly requires a mix of finance and psychology.

The first issue is getting a better understanding of what cash flow break-even might mean. The conventional cash flow statement is formed from three main types of flow. Briefly, cash flow from operations is cash from the core business of producing and selling goods and services. Cash flow from investing is basically capital expenditure, buying and selling items such as property, equity and machinery, as well as long-term investments. The third type is from financing, such as selling equity in the company or getting a loan from a bank.

It is clear that the most important cash flow is from operations, as it tells you if the business is covering its cash from its core business. Looking at total cash flow, or how much cash is in the company’s bank account, distorts the picture, as an all-too-common mistake is to believe that cash flow from financing is a viable long-term option.

Even when focusing on operating cash flow, one cannot do so blindly. The working capital of the company, a measure of its short-term liquidity position, can also distort the picture. The usual method is by increasing accounts payable – delaying payments to suppliers – while holding accounts receivable steady – demanding that customers continue to pay in a relatively short time period.

The trap with playing this working capital game is two-fold. The first is that it only works for as long as the business is expanding quickly. Once this initial period ends, so do the benefits of this cash management hack. The second issue is that it upsets, to put it mildly, the suppliers.

Another trap that leads companies to fall into the break-even zone is misunderstanding the operating margin that relates to the income statement as opposed to cash flow, but there is still a strong connection. Operating margin is the ratio of profit to revenue, or more generally how much of each dirham in sales makes it to profit.

During the initial loss-making period, a start up will have a negative operating margin. As the operating margin improves and goes from negative to positive, the company becomes profitable and cash flow will usually improve commensurately. The problem can be clarified by understanding that operating margin can be decomposed into variable cost, fixed cost – buildings, IT systems, and executive management – and revenue.

As an example, consider a company with a Dh10 million fixed cost. This company also generates Dh1 for every Dh1 spent on variable cost. In the early stages of the start-up it might spend Dh1m in variable cost to generate Dh1m in revenue for a net loss of Dh10m and an operating margin of minus 10. The company spends more, say Dh10m, and therefore generates revenue of Dh10m, loss of Dh10m and operating margin of minus 1.

What a wonderful improvement in operating margin. But wait, what if the company spends Dh50m? Operating margin improves to minus 0.2 but still is not positive. Spend a billion? Operating margin is minus 0.01. No matter how much this company expands, it is driving margin improvements by expense expansion and will never become profitable. This tragedy, when it plays out in multinationals or even larger institutions, leads to billions being wasted chasing a financial mirage.

The psychological part of the analysis has to do with the human bias to overweight nearby risks over risks that are further out. Sometimes this bias is useful, but when the risks are interrelated it is can be extremely dangerous.

A race to cash flow break-even will usually lead to decisions that stop the company from being able to grow positive cash flow. A simple example is the above – a marginal profit of zero can be useful to reach cash flow break-even, but is useless in moving past it. Positive cash flow growth simply is not a linear extension of break-even.

Sabah Al Binali is an active investor and entrepreneurial leader. You can read more of his thoughts at al-binali.com

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