Overview – Are Revenue and Cash the Same Thing?
Let’s say you are analyzing a company’s income statement and you find out that last year they earned $10 billion in net income. For most companies, bringing in $10 billion in net income is an impressive feat.
However, despite the impressive net income, you find out that the company is facing liquidity problems. That is, they don’t have enough cash on hand to meet short-term cash commitments such as paying the bills or paying employees’ salaries. How can that be the case if they brought in $10 billion in net income last year?
In personal finance, this is the same as being asset rich but cash poor.
This difference between revenue and cash was talked about briefly in The Annual Report & Financial Statements and Understanding Ratios and Metrics. In this article, we will go over exactly what the difference between revenue and cash is and why that distinction is so important.
There are some nuances in the definitions of revenue and cash when discussed in the context of economics, but for the sake of simplicity, we will not be looking at those nuances.
Understanding Revenue
Before looking at the definition of revenue, let’s take a step back and look at the definition of income.
There are different ways to define income, based on the level of economic sophistication you want to deal with, but I like to think of income as “the monetary value of an exchange between two parties”.
Let’s say every month you work 160 hours (assuming 4 weeks, 40 hours a week), and your income every month is $5,000. In exchange for 160 hours of your time, in the eyes of your employer, your labour is worth $5,000.
That $5,000 is usually given to you in the form of cash (e.g., a direct deposit into your bank account) or some other financial asset such as shares of company stock.
$5,000 is the dollar amount you can go out and spend on goods and services that you want (assuming taxes have already been deducted).
When someone says “I can’t afford that”, they are quick to say that they don’t have enough money. There is plenty of money available, what they really mean is that they don’t have enough income.
Revenue is the income you earn from the sale of a good or service. If someone agrees to buy $1,000 worth of cookies from you, the income you generated from the sale of those cookies (i.e., your revenue) is $1,000.
It’s possible to earn revenue without a single dollar of cash swapping hands; in fact, it happens every day.
When you purchase something using your credit card, the merchant (i.e., the one selling you the good or service) would record an increase in their revenue, but they have yet to receive any cash. (To learn more about credit, click here.)
This setup of a merchant recording revenue without any exchange of cash is called an account receivable (or a receivable for short). An introduction to the basics of accounting is discussed in another article, but essentially a receivable is a monetary amount that a company expects to one day receive in cash.
Once you pay off your credit card balance, the merchant you purchased from receives the cash, and the receivable balance becomes $0 (the receivable has been paid).
Understanding Cash
The definition of cash introduces even more nuances because the definition may differ slightly if you’re talking about cash in a finance or economics context.
A full, economics-based definition of cash leads to another definition, which then leads to another – we can quickly spiral down an endless rabbit hole just trying to explain the concept of cash.
For the sake of simplicity, and in the context of investing/finance, I like to think of cash as “the most immediate method to exchange value”.
Cash can exist in both physical and digital forms: A $20 bill and $20 in your chequing account are both forms of cash. “Currency” is usually understood as being the physical form of cash.
Before the existence of cash, goods were usually traded via a barter system. A classic example of a barter system is the Canadian Fur Trade.
Imagine Party A is selling 5 cows in exchange for 20 bushels of wheat. Party B is interested in trading with Part A, but they only have 10 bushels of wheat. However, because of Party A’s condition, no exchange will occur.
This is where cash comes in. Instead of trading a fraction of a good, we can instead give cash in exchange.
So, instead of Party B trying to negotiate how many bushels 2 cows are worth, he can simply give cash in exchange for the 2 cows.
Cash is universally accepted as a form of value, hence the reason why cash transactions go seamlessly: both parties receive the value they want right away.
Let’s go back to our example of selling cookies. If someone buys $1,000 of cookies from you using their credit card, the customer walks away with the cookies, but you walk away with a promise that they’ll pay you in cash at a later date.
You’re essentially left with a promise from someone saying they’ll pay you back $1,000. If you attempt to buy something for $1,000 using this promise, you may run into some issues.
Now, if the customer purchased the cookies from you and paid you $1,000 in cash, you can immediately go and use that cash to buy $1,000 of goods that you want without any hassle. This is because most merchants understand that by receiving cash, they receive something of value that can immediately be used to make their own purchases.
A company can’t expect to pay constantly pay the bills, repay their debts, or pay employee salaries with a promise. Eventually, these parties will get fed up with the promises and will demand something tangible as a form of payment – cash.
Imagine it’s your payday and instead of receiving a direct deposit into your bank account, you receive a note saying that you’ll receive $5,000 at a later date and that this promise has a chance of being broken. Most employees would probably riot if that were the case – promises can’t pay the bills or put food on the table.
Why This Distinction Matters to Investors
Understanding the difference between revenue and cash is crucial because an investor can easily misjudge a company if they don’t know the difference.
If a company posts impressive revenue, one of the first things you should ask is “how much of this revenue is comprised of receivables?”
An investor can check the current receivables balance a company currently has by looking at the balance sheet, but remember that the balance sheet is a “snapshot”: the receivables reported are only for a given day, not over a period of time.
Remember that a receivable is a promise of later payment. Until the receivable is fulfilled and the cash is received, there is always the risk of that receivable not being honoured.
If a customer buys $10,000 worth of goods using their credit card but ends up filing for personal bankruptcy, the company can say goodbye to that $10,000 in cash they were going to receive.
There’s nothing wrong with having a receivables balance – not every customer may be able to buy the good or service straight up, so they opt to use credit to repay it later. The problem is if the bulk of a company’s revenue is comprised primarily of receivables – if a sizeable portion of receivables aren’t collected then a company will quickly find itself strapped for cash.
Investors usually start to become worried when a company consistently fails to generate free cash flow because the company may soon find itself struggling to meet short-term cash commitments such as dividends or payments on current loans (i.e., loans that are due in under a year).
This is why investors obsess over free cash flow. Free cash flow is the cash available to repay creditors and to pay dividends after paying for capital expenditures. Strong revenue is great, but receivables can’t be used to pay investor dividends or interest payments on bonds.
Make no mistake, strong revenue is still an important indicator of company health and investment merit – there’s no debate about that. Revenue is a direct indicator that a company is able to successfully sell its goods and/or services. It’s very hard to convince an investor to put their money into an enterprise that can’t demonstrate that ability.
However, there’s a bit more to revenue than meets the eye, which is why investors should take the time to dig a bit deeper to understand if the cash figures are just as healthy as the revenue ones.
Wrapping Up
Revenue and cash are closely related concepts, but they have differences that investors should be wary of.
Just because a company posts impressive revenue doesn’t automatically mean investors should start celebrating. If a large portion of that revenue is in receivables, then investors should start asking some questions, such as “when will these receivables be converted to cash?”
Revenue is an important indicator of investment merit, there’s no denying that. However, strong revenue and strong cash flow should go hand-in-hand.
A company that finds itself strapped for cash is a very serious problem that, if not corrected right away, can lead to even larger problems for both the company and its investors.
