Almost by accident, I learned a little bit about accounting as I read. I was already familiar with the basics (like revenue and cost) and I managed to understand some of the trickier concepts (such as EBITDA) after reading a few posts (1). The most interesting idea to me was cash flow. Cash flow problems explained why massive soccer clubs could generate hundreds of millions of dollars per year in revenue yet stumble over a payment just a fraction of their revenue if they did not have the liquidity required to take out a short-term loan required to cover a cash shortfall.
I understood cash flow in a general sense, of course, in the way anyone who has taken out a loan or needed to pay the rent understands. But I never thought about it from the business angle. I always thought a company's main financial concerns were revenues and costs. A widget costs $10 and the price is $15- if the business sells one widget, the profit is $5. Simple, right?
But the oversimplified example does not take into account the influence of cash flow. A widget reaching the retail shelf costs $10 but this cost is paid before the revenue from the sale is booked. A business sloppy with forecasting might fall shy of the cash requirements for buying raw materials, meeting payroll, or renting space. If the cash runs out before sales become consistent, it is possible to go out of business despite the revenue-cost consideration suggesting a highly profitable model.
I think one reason why the rich do better with their money than the non-rich is because of cash flow. A rich person likely has access to better short-term credit options and thus invests in longer-term assets. These assets return more in the long-term because they are generally locked out of reach for the duration of the investment vehicle. The less well off, on the other hand, might hold more cash in reserve because their confidence in overcoming unanticipated cash flow crises is low and their options for short-term credit to cover such events are limited.
When financial 'wizards' remark on America's low retirement savings rate, I think what they are failing to acknowledge is how the threat of a cash flow crisis impacts personal finance decisions. An IRA or 401k plan often requires the money remain untouched until retirement age (those who withdraw early are penalized). Well, I have thirty to forty years left before (completely) retiring. So, until I'm confident of being able to handle a short-term cash emergency, each dollar invested in a retirement account is an additional dollar I might have to borrow later at high interest rates to address any sudden cash flow requirements. Given the trade-off, I could see why those who are young, struggling to make ends meet, or lack options during a cash flow crisis might choose to avoid retirement accounts entirely until their liquidity improves.
Footnotes / imagined complaints
1. I-bit-the-what?
EBITDA stands for 'earnings before interest, tax, depreciation, and amortization'. When I unpacked the acronym, I had to also learn what 'amortization' meant.
This proved more interesting than logic would dictate. When a soccer team buys a player from a rival club, they are often required to pay a fee to the team's former employer. This is known as a 'transfer fee' and the numbers for the top players get pretty high. If a player moves for 'big money', it is generally when the transfer fee reaches twenty or so million pounds/dollars/euros.
The accounting side writes off the expense over the length of the deal. A player who cost $20 million in transfer fees over a four-year contract is considered a $5 million per year expense over those four years regardless of the payment schedule for the transfer fee. If the fee is paid in an upfront lump sum, the club is out $20 million cash but the accountants would book $5 million over each of the next four years.
