If you have earned profits, have you also maximised wealth? May be (not!)

The learning curve of trying to build a profitable business is massive but what is even harder is to make it wealthy i.e to generate stable amount of cash flows.

Often more likely than not, the words “profit” and “wealth” are interchangeably used by businesses, investors, and other stakeholders. Although the two are interlinked, they are quite different from each other.

Is your business earning profits or making wealth or both? It is not always the case that profitable businesses are making wealth and wealthy businesses are earning handsome profits.

Most of the investors today take a call to invest money in a certain business just by looking at its profitability. However, that may not be the right approach for the evaluation of investment.

Let us take an example to understand this clearly.

Real Ltd bought 10 mobile phones at INR 20,000 each and sold all of them at INR 35,000 each during the financial year. The profit and loss statement of Real Ltd will look as follows:

Sales = 3,50,000

Cost = (2,00,000)

Net Profit = 1,50,000

Net Profit as a % of revenue: 43%

Based on the above information one would generally tend to think that business is making a net profit of 43% and therefore is booming. However, one may be wrong here.

Real Ltd has definitely made a profit but whether it has created wealth for itself?

What if the customers have not paid the sales amount of INR 3.5 lakhs and the entity has already paid its vendors Rs 2 lakhs? Therefore, the entity may have earned a profit of Rs 1.5 lakhs as indicated above but not generated wealth out of such business. Instead, all the cash is blocked in debtors (which may or may not be collected). Such a business has an adverse working capital since it is not able to liquidate its receivables into cash, in other words, a cash strapped business.

Trade receivables = 3,50,000

Bank Overdraft = (2,00,000)

Working Capital = 1,50,000

Furthermore, tax is charged on the profits of the business (INR 1,50,000) i.e., the Income-tax for which the Real Ltd may not have the cash to pay.

When evaluating/analyzing a business, profitability alone will not give a complete picture but cash flows also have to be taken into account to understand the working capital of the business which leads to how much wealth the business can make.

On the other hand, businesses with surplus cash and short-term investments may also not be favorable unless they are maintained for some specific purpose. Surplus cash has zero value in finance. It must be reinvested in the same business or other businesses to generate returns i.e., wealth generates profit. This investment decision must be made carefully considering the risk appetite, returns, volatility, time period among other parameters.

Continuing the above example, if Real Ltd can collect from its customers then surplus cash would be created amounting to INR 1,50,000 in the business. If the cash is kept idle by Real Ltd, then it would be of no value. Instead the same must be reinvested in the same line of business or some other business to generate profits!

Business mismanagement can be broadly categorized in two ways :

  • Operational mismanagement– Business is unable to thrive since it is unable to capture the market, good customers, profitable contracts. In other words, the business is unable to make profits. Operational mismanagement can be attributed to multiple reasons including poor marketing, product/service inefficiency or obsolescence, unskilled employee force, etc.
  • Financial mismanagement- Business maybe making profits however cash flows are not managed properly e., the business is unable to maintain a favorable working capital position. As a result, though the entity may have very profitable contracts still it would be pushed to an insolvency position. Reasons for this kind of mismanagement include weak account and finance function, improper receivable and payable management, frequent and unnecessary borrowings, non- prioritization of payments, weak MIS reporting process, etc.

Therefore, the right balance needs to be struck between maintaining profitability and wealth. Businesses should enter contracts that are profitable but should not forget about maintaining a healthy working capital position i.e., properly structured cash flows from receivables and reasonable credit from vendors. Thus, good profitability and a healthy working capital position would create great wealth for the business which in turn should be reinvested in better investment avenues.