BS Earnings and Unconscious Reinvestment
I guess I shouldn’t have been surprised that more than a few people were interested in what Permanent Equity does with its money. After all, it’s one thing to brag about bullshit earnings (shoutout Charlie Munger) and another to be able to buy beer. And what people wanted to know most is how much cash our companies actually generate?
The answer to question one is a moving target because we live and work in the real world where nothing is ever reliably stable let alone up and to the right, but we have aspirations that our portfolio companies generate in cash at least 90% of what they claim to have earned in a given month. Some call this free cash flow conversion, but we refer to it as earnings quality, and if any of our companies come up short of that 90% target in a given month, and we have spreadsheets to measure it, we want to understand why.
That’s because it’s in understanding why a business did or did not have good earnings quality that a lot of aha moments happen, in particular with regards to operating a small business. For example, one idea I’ve come to believe is that reinvestment, which is what is happening if earnings are not showing up on the balance sheet in cash, takes two forms: (1) conscious and (2) unconscious.
Conscious reinvestment is great. It’s the deliberate deciding on and then spending against a strategic priority whose risk/reward profile is both known and attractive. And if we have a business that’s not generating much cash because it’s consciously reinvesting, that’s, again, great. We’re using pretax dollars to drive growth and the cash should show up later.
What’s insidious, however, is unconscious reinvestment. This is what I’ve started calling it when a bunch of invoices get paid early because someone is on vacation next week, we decide to buy instead of lease some new equipment to get a price break, we hired someone a little earlier than plan because it was a serendipitous fit, and the back office got busy and missed a billing cycle or didn’t make any phone calls to inquire about past due receivables.
Because each one of those decisions on their own isn’t the end of the world, but if they all happen in the same month, and they can because different individuals are the decision-makers and they may not be coordinating, poof, our earnings quality may have just got cut in half without anyone realizing it. And God forbid if you fill that gap with a draw on a line of credit without figuring out why the gap exists in the first place.
That’s why having a goal of banking at least 90% of its earnings is effective. It doesn’t mean it will happen every month, but if it doesn’t, and you’re not consciously reinvesting, at least the shortfall will shine a light on your unconscious reinvestment and therefore on what process improvements need to be implemented in order to nuke it.
-Tim