Ramon Ecung's Personal Blog

Some companies that may look profitable based on their cash on hand actually require a deeper look.

Absolute Software (http://www.absolute.com/) is a company that makes software that tracks computers when they get lost or stolen. The company works with partners such as Dell to provide it’s services to end users. The company charges $100 per end customer user, and $129 per corporate user up front for three years of service.

If Absolute Software sold 2,500 home end customer units in a month, they would have a positive cash flow of $250,000. This lo oks like a great month, right? Even if you assume that they have priced their product at a profit (the revenue per sale is greater than the expenses of getting the sale and fulfilling it’s obligations), the story isn’t as great as it seems on paper.

The $100 from a customer actually represents unearned income. After providing 30 days of service, they will have earned about $2.79 that they can then “book” and add to earnings, while the remaining $97.21 is still in the unearned income account because you haven’t provided those services yet.

Going back to the previous example, after the month where Absolute Software obtained $250,000, they actually earned $6944.44 (don’t confuse this number with profit!).

Of course since the company has $250k in the bank, they can use the money to expand operations, pay salary, or leverage it. That’s one of the great things about cash, after all. As a business owner, you have to be careful to manage that cash. It’s possible to spend too much of the cash from revenues on other expenses, and then not be able to provide the services that your customers have already paid for.

This is similar to the case of Steve and Barry’s, a discount clothing retailer that closed due to a loss of revenues. Sources close to the company said that they were actually able to make profits because the malls and shopping centers were paying them millions of dollars to open stores in their retail outlets. They then took that money and provided their products to consumers.

Even though they were not making a profit from their retail outlets, they were able to make profits from the amount of cash they were getting by opening new stores. Once the money from the malls dried up, they were forced to raise prices in their stores which ran off customers, and lead to the company filing for Chapter 11.

If an investor read the Statement of Cash Flows, they would have seen where the company was getting it’s cash from, and should have questioned how they were going to make their main business unit profitable to remain in business for the long term. (The Collapse of Steve and Barry’s, http://www.dailyherald.com/story/?id=220900)

It’s vitally important to understand where a company’s cash comes from, and if it’s coming from a questionable source, be sure to know how they plan on turning the corner, or you may end up crashing into a wall.