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Some Truths About Profits
Friday, August 23rd, 2019
As strategists, we love talking about profits, and even our own definition of strategy has been narrated around the idea of "maximizing profits" within the foreseeable future. But if you look closer into how profits are calculated, you quickly realize that they are not what many expect.

In its most basic definition, profits (the "bottom" line) mean the difference between sales (aka revenues or the "top" line) and costs, but have you ever wondered how sales and costs are calculated?

Here are a few facts about revenues and costs that highlight their true nature:

1. Sales are just an estimate: Under the Generally Accepted Accounting Principles (GAAP) sales, or revenues, have nothing to do with cash coming through the door.

Under GAAP rules, accountants must record a sale when it has been earned, but it is up to them to decide when that happens.

For example, an accountant in Company A may decide that a sale happens when a contract is signed, while accountants in Company B say that a sale has been earned when the product is delivered or when a service is completed – even if buyers have not paid yet.

In most cases, what you see as revenue in an Income Statement rarely matches the period when the funds are actually received.

With the exception of cash businesses, revenues are your accountants’ best guess of when sales were earned, even if no money changed hands.

2. Costs are an estimate: The same GAAP liberties apply to costs, so as a result costs, as shown in your income statement, are also an estimate.

When calculating profits accountants stick to what they call the matching principle which says that costs and expenses must be reported only in association to the sales recorded during the reporting period.

That means that a company that buys a truck for $100,000 and plans to use it for 10 years will only record $10,000 every year on its income statement as the cost of the truck, even if it was paid in full upfront.

In another classic example, a company that makes $10 million in sales in a given year and pays out 10 percent in bonuses to its salesforce has to record the $100,000 bonus as a cost during the year the sales were made, even if the bonuses are paid out the following year.

Furthermore, your accountants also get to decide whether a piece of equipment will last 10 years or only 5 for financial purposes, affecting the profitability during a particular period.

What all this means is that as a result profits are just an estimate of how efficient a company is at converting expenses into revenues, but it doesn’t tell you much about a company’s ability to meet its cash commitments.

That’s why I always advise using cash-based metrics to measure the performance of an organization.

That means that your performance as an executive should be measured by your ability to convert profits from the Income Statement into cash in your Balance Sheet.

The good news is that Wall Street seems to be listening. After a number of cases of accounting fraud and trickery, market analysts and investors are shifting their preferences towards cash-based metrics.

The truth is that accounting rules make every profit metric no more than a good guess, except cash. Cash is cash, and money in the bank is really hard to fake.

Can you fake a million dollars in your bank account?

I don’t think so, but if you can, I’d love to hear about it.

From Around the Web
A lot of interesting news this week so let’s dive right into it:

CEOs Say They Don’t Just Work for Shareholders. Do They Mean It? (HBR)
The Business Roundtable made a bold announcement this week trying to shift towards more inclusive metrics for management. Do they mean it?

Getting Personal About Change (McKinsey)
The need to shift mind-sets is the biggest block to successful transformations. The key lies in making the shift both individual and institutional—at the same time.

Three Reasons To Be In Favor Of A Payroll Tax Cut (Forbes)
Despite the President's urging that we cut interest rates, that would do very little. However, the latest suggestion of a payroll tax cut is at lest in the right direction.

AI is Solving Banks’ Very Expensive Research Problem (Bloomberg)
Using artificial intelligence to automate swaths of the research process is quickly gaining traction because cost-conscious investment banks are downsizing.

Overstock CEO Resigns After Disclosing Romance With Russian Agent (NYT)
Patrick Byrne’s resignation came roughly a week after he publicly disclosed that he had a relationship with Maria Butina.

Meet America’s Makers: 25 Manufacturing CEOs Thriving In The U.S. (ChiefExecutive.net)
Depending on what you hear and whom you believe, American manufacturing either has begun a fundamental renaissance that will outlast the vicissitudes of geopolitics—or it is enjoying a last gasp before being finally laid low by trade wars, labor mismatches and a recession.

 
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