Why Measuring Cash Flow is More Important Than Measuring Profitability
by Cedric Chin
This is part of a series on business fundamentals for data professionals.
One of the most interesting — if counter-intuitive — things about business is how important cash flow is for the continued operation of the company.
Traditionally, the finance department is responsible for financial reporting. This role is so important that the finance department usually reports directly to the CFO and CEO. But if you are in a smaller organization — or a company that transacts digitally, like some software startups today — you may find that the financial reporting function falls to you in your role as analytics provider.
(The way I imagine this happens is that your CEO walks in one day and tells you: “Say, wouldn’t it be a good idea to take our Stripe revenue numbers and display it on our internal dashboards? Terrific idea, right? Make it happen!” And then you have a new thing to do.)
This piece explains why your CEO might be so obsessed with cash flow. More importantly, it explains why measuring cash flow is often more important than measuring profitability. Like our previous piece on the SaaS quick ratio, this essay is written for the data analyst in mind, so it assumes no prior business knowledge.
Let’s get started.
Cash Flow, Defined
Cash flow is the amount of money that flows into a business minus the amount of money that flows out of a business in a given time period. This sounds simple until you realize that time is the key phrase here: the timing of these cash flows matter a great deal to the solvency of your company.
We’ll start with a simple example: imagine that you’re a fruit seller in one of the street markets in Vietnam. You buy your stock of fruit from a supplier first thing in the morning, and then set up your stall at 6am. You’ve paid for the fruit out of your working capital — that is, from the money you have in your pocket. You must now sell enough of your product to make back that money, and hopefully also a little extra for your living expenses. If you end up with less cash than when you started, you’re in trouble.
This is the most basic form of business.
At a fruit stall, you pay your suppliers in cash and receive payment in cash from customers. This means that your cash flow and income are one and the same. However, in larger businesses you may have customers who purchase goods now but pay later (accounts receivable) and you may yourself purchase goods or services from suppliers today but pay later (accounts payable). In other words, a company may make a sale today and record it as profit, but the real cash only arrives in the company’s bank accounts a period of time later. The timing of these payments affects the state of your company’s cash flow … and, well, it affects the overall state of your business.
Why is cash flow so important?
Cash flow is important because you pay your bills and your salaries in cash, not accounting profit.
This seems trivially obvious, but it’s surprising how often people forget it. Software companies tend to book enterprise deals as profit the month in which they were confirmed. But it doesn’t matter if you’ve booked a million dollar profit if that cash isn’t yet sitting in your bank account. Good CEOs know this, so they keep an obsessive eye on the cash flow situation of their business.
The importance of cash flow also explains certain interesting behaviors that may or may not exist at your company. I used to work at a hardware reseller who served other businesses. Early on in the business, I was surprised at the number of times my boss would concede to additional discounts in order to receive payment early — I always thought this was unwise; why was he was leaving so much money on the table? But he later explained to me that it was worth it to take a hit on profit if he could receive payment as soon as possible. Otherwise, the money would effectively be locked up in inventory and would not be redeployable for other uses within the business.
Investor and business person Tren Griffin likes to quote Wu-Tang Clan’s ‘C.R.E.A.M’ — or ‘Cash Rules Everything Around Me’. He uses it as a mantra, in order to remind business people to watch their cashflow. Sometimes, he even goes so far to say that people should ignore accounting profits! This sounds ridiculous at first but is in fact common sense when you pause to think about it: profitable(!) companies that lack cash and are unable to borrow to fulfil their obligations are usually in serious trouble: they go bankrupt.
What Does This Mean for You as an Analytics Person?
For all of the digitization the banking sector has experienced over the past decade, a surprising amount of financial work still occurs via manual labour. Your finance department compiles invoices and submits account statements to the CEO at the end of every month. This is analytics — in the true sense of the word — but it is not something that typically lives in a dashboard.
On the flip side, a small but increasing number of online-first startups process their payments through platforms like Stripe and Paddle. In these companies, it is usually possible to pipe your financial data into your analytics stack, perhaps by using a third party tool like Stitch or Fivetran.
The upshot is that if your boss is obsessed with cash flow-related metrics, this is why: cash flow matters so much to the ongoing nature of the business that he or she must keep close track of it. Anything you can do to help your executives access this data repeatably and reliably will be greatly appreciated.
If you can get this data in a dashboard: so much the better. Your company may now run with a constant understanding of its cash flows. This is good for your CEO, good for your company, and ultimately, good for you.
This is part of a series of posts that explain business fundamentals to the data professional. For more updates, subscribe to our newsletter below:
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