In the coming year let us conduct our affairs like a well run company.
In some parts of the world to tell the future you may tea leaves or animal entrails, to have an insight into a company’s future we read their financial statements.
The financial statements – the profit & loss, the balance sheet and the cash flow statements are like an x-ray into the business allowing even an outsider a better than good idea of a company’s fortunes.
For the experts, bear with me – and I stand to be corrected.
The profit & loss (P&L) tells us whether a company has a healthy relationship between its revenue and costs. A healthy relationship would be profitable with revenues coming in higher than costs and unhealthy one vice versa.
The balance sheet – a statement of assets and liabilities, is where the durability of the company can be found. A business with more assets than liabilities can be said to be healthy and have a future while a company with liabilities more than its assets, has no future or a bleak one at best. I am speaking in general terms of course.
They say profit is an opinion but cash is reality and that is where the cashflow statement comes in. The cashflow statement gives an account of how the money is entering and exiting the company. You can be profitable all you want but if you are not collecting what’s due to you while paying your dues it’s a matter of time before you will be out on the street.
Without knowing the aforementioned many of us focus more on the P&L part of our finances. We want to earn more so we can spend more, essentially improve the standard of our living. Interestingly the more we earn the more spend. It is the rare person or country that will have expenditure holding steady or growing slower than earnings.
The best companies retain part of their profits or invest in new plant and machinery to increase production and marketshare.
Unlike most individuals the best companies focus on their balance sheet, because as said earlier it’s the balance sheet that ensures longevity. If a company suffers a bad year it can either dip into retained earnings or sell off assets to tide themselves over. When an individual loses his or her job many are reduced to abject poverty, because they did not save or build their asset base.
Another lesson we can learn from the best companies is that they are adept at converting liabilities into assets. These assets then throw off higher incomes allowing them to retain more earnings and invest in more assets, a veritable virtuous cycle of prosperity.
We on the other hand take out loans to finance consumption. Essentially we eat the money with no new income created. We therefore find our unchanged income constrained in paying off new debts, which prevents us from saving or buying new assets, therefore no new or lower income – the vicious cycle of poverty.
Investors while valuing companies look at income but more importantly they look at the balance sheet to see whether existing income is sustainable or can be raised. Using the same measure on ourselves it’s all very nice that we are pulling in multi-million shilling incomes but does our balance sheet indicate sustainability of this situation?
One more thing about the balance sheet, the quality of an asset is determined by how much income it is earning. It is all very nice to have tracts of landing in the village but if they are not making money chances are they are costing money and cease to be an asset.
Unrealised income is all very nice, for example that you bought land for sh1m two years ago and the same land is now sh5m today, but this does not put bread on the table. So the best companies are always seeking to “sweat” their assets, make sure they are producing and if not liquidate.
So in the New Year the bottom line is not the bottom line. In our personal lives we should focus on the balance sheet: It is not how much we earn that counts but how much we keep.
Have a prosperous New Year!