Cash flow and profitability are both extremely important financial concepts in business for the simple reason that cash flow is the lifeblood of a business and profit is often an important source of cash that a business uses to reinvest back into the business, reward shareholders and make the business worthwhile. Without sufficient cash flow, the business cannot afford to pay its running and operational costs, which eventually is likely to result in failure. There is a saying often heard in business which is:
`Turnover is vanity, profit is sanity, but cash is king`.
This effectively means that the cash available to cover the running costs of the business (cash flow) is the most important financial factor in business.
There is a common misconception that profit is the most important indicator of the financial health of a business. However, the failure to make a profit does not always mean the death of a business (at least not in the short term). The reasoning behind this idea will be explored and explained in this article using Tesla as an example of an exceptionally valuable automotive company that has never made a profit, but yet still has an exceptional share price and eye-watering future potential.
Profit is the difference between the turnover (how much money the business took in total from business activities such as sales) and the total costs of the business. Most businesses use profits that are re-invested into the business and their main source of finance so it is often a good indicator of a business’s financial health. Most businesses will expect and aim to make an overall yearly profit. However, it isn’t essential for short term survival. This is because there are other ways to raise finance for a business other than by re-investing the profits made.
One example could be by using angel investors, this involves privately selling shares to individuals who invest large sums of money into businesses with the hope of making a return on their investment as the business grows. Another way that the business could raise finance is through share capital which means selling shares in the business on the stock market. It is worth noting that this is usually only an option for large businesses who want to raise a large sum of money quickly, the business must also become a public limited company to list shares on the stock market. This is done via an IPO.
So, as long as a business can acquire finance in some form or another, the profit is not necessarily the determining factor for the success of the business. Instead, it is more important to have effective cash flow management which involves ensuring that the business has enough available cash to settle the costs and debts of the business.
Cash flow as an indicator of a business’s financial health:
One reason why cash flow is such an important indicator of a business’s health is that cash flow takes into account the timing of money coming into and leaving the business, these are known as cash inflows and outflows. The net cash flow is the difference between these sums.
This arguably makes cash flow more important to a business than the profit. This is because a company could make huge profits on paper, by making lots of their sales on finance via sales credit (meaning that the customer can buy now pay later). But this means that the money will arrive in the business bank account at a later date – often years into the future with valuable purchases.
So if the business is careless and allows customers to buy too much on `buy now pay later deals` – then the business might not have enough cash to pay the day to day running costs in the short-term. This could be a catastrophic problem ultimately causing the business to fail. This problem is particularly relevant to Tesla as it has been reported that 86.5% of new cars purchased in the 12 months up to March 2020 were purchased on finance deals.
Cash flow also takes into account sources of cash other than profit such as money from shares and investments and even the private funds from the owners of the business. If you inspect Tesla`s income statement, you will see that the business does not have good profitability. However, if you look at the balance sheet, you will see that the business has a positive net cash flow, meaning that the business has enough cash from various sources such as share capital to cover their research, development, and running costs for the time being.
How can Tesla survive without making a profit?
Tesla is a cutting edge automotive company which over the last few years has become a household name, mainly due to its revolutionary technology such as long-range electric batteries and more importantly their world-leading `Tesla autopilot system`. Consequently, Tesla is a business with huge costs in research and development, but the electric and self-driving car market is a long way off its peak, with the vast majority of customers still choosing to purchase traditional fossil fuel vehicles. This means that Tesla`s sales turnover is currently too low to cover these costs meaning that the business does not make a profit.
In 2010, Tesla launched its initial public offering (IPO), which means the first time that a company is listed on the stock exchange. The aim of this was to sell shares in Tesla to raise money to fund the business’s running costs whilst they don’t make a profit from the sales of their vehicles. This finance raised from selling shares to investors is used to finance the business in the absence of profits available to re-invest.
How sustainable is a business such as Tesla that does not make a profit?
Tesla which was founded in 2003 has experienced significant growth despite not making a profit since its founding. Investors who invest in businesses are above all else taking a risk. The risk is that they might invest lots of money into the business and not get a return if the business performs poorly or even fails. Investors invest in a business based on the confidence that the share price will increase significantly, or the business will perform well in terms of profit in the future, meaning investors are likely to get a return on their investment. This is why share capital has been such a good source of finance for Tesla because the business is developing ground-breaking and unique technology such as Tesla Autopilot and is the market leader in electric vehicles. This means that in the future as traditional vehicles are phased out, Tesla will be in an extremely strong position in the market and is likely to be much more advanced than other manufacturers, so in the eyes of investors, Tesla has huge growth and profitability potential in the future.
However, if a business continues for a very long time without making a profit, and doesn’t show any promise of making a profit in the future, investors won’t be incentivised to invest in the business, meaning that the share price will fall due to a lack of demand for the shares. Consequently, the business will not be able to fund itself as effectively because there would be a lack of finance from investments.
In conclusion, a business that does not make a profit is only sustainable in the short term and businesses that manage to survive for a long time whilst making a loss are only able to if investors can see strong potential for future performance. The main point to take away from this article is that ensuring you have enough cash to finance the day to day running of the business is the key to business success.
By Jack Eaton – University of Reading
All BeComAware content is reviewed and approved by a professional in industry.
Test your commercial awareness:
1. What is the most important type of capital for a business?
B. Cash flow
2. Can you explain why in one sentence?
3. How do Tesla have sufficient cash flow without making a profit?