In our last post we talked about the challenge of understanding both how volatile revenues and expenses are for small firms, but more importantly how much, when, and how volatility matters. There is an important part of managing volatility that we didn’t discuss in that post: profitability.
A firm with a healthy profit margin will find it much easier to deal with volatility, in general, than one with very small margins. Larger profits make it easier to save, easier to borrow and easier to absorb short-term shocks. But calculating the profitability of a firm is devilishly difficult.
Why is it so difficult to measure whether a firm is taking in more than it’s spending? It seems a fairly simple concept. But if you pause for a moment to think about all the rules that have grown up to govern business accounting—enough that a tertiary education is necessary—you begin to grasp the problem. Or think about all the different ways that “profit” is reported by public companies: there are “earnings”, and “earnings from continuing operations” and “earnings before interest, taxes, depreciation and amortization (EBITDA)”; and that’s before you get to all the idiosyncratic “preferred measure of earnings” that many companies report.
Let’s break down some of the issues.
First and foremost is the question of the timeframe in which to measure profits. Even the simplest firm is going to incur costs before it has revenues: inputs and labor, at the least. So the famous basket weavers that caught Mohammed Yunus’ attention were not profitable at the beginning of the day when they bought their raw materials, but were by the end of the day, even after paying back their high-interest loans (just not very profitable). Clearly no one is suggesting that we should measure profits hour-by-hour (though ironically, gig workers do essentially have to do this), or even day-by-day. But what is the right unit of time?
To illustrate, here’s a slide we shared during our last Global Advisory Board Meeting:
This chart shows data from the first 11 weeks of data collection for 10 firms (labeled A through J) in our Ethiopian sample, with three different ways of looking at the flows: weekly average, weekly median (with ranges) and bi-weekly medians. You can see the averages, while clustered close to zero, hide a good deal of volatility for most firms; and that the bi-weekly median is materially different for a few firms. As we get further into data collection in each of the countries, we’ll also be able to calculate medians on a monthly and quarterly basis.
With the Small Firm Diaries, we’re conducting weekly interviews with small firm owners, and asking them to record all cash flows in and out of the business. You may note that we use the term “profits” on the slides. Global Advisory Board members were quick to point out that what we were showing was “net cash flow” not “profit.” Why? Because revenues may depend on expenses that were incurred before the week in question, or may require costs in the future (for instance if a customer prepaid); and the costs incurred may turn into revenues far into the future (at the most basic level this is why financial reports make a distinction between “cash basis” and “accrual basis.”)
That doesn’t mean that net cash flows are unimportant. But whether a week’s or month’s net cash flows are positive or negative isn’t sufficient to tell you that much about how a firm is doing. Especially given how volatile those net cash flows are. Here’s a slide from the meeting showing weekly net cash flows (again, incorrectly labeled as profits) of firms from our Ethiopia and Colombia samples over several weeks.
You’ll likely note that while there is a lot of volatility, there’s also a lot of clustering just above and just below 0. While any particular week’s net cash flows don’t necessarily tell you much, persistent flows that don’t stray very far from breakeven likely indicate challenges managing liquidity and difficulty amassing the lump sums necessary for significant investment (for more on the challenges of managing liquidity, and the difference between illiquidity and insufficiency, check out the video of Tim’s discussion with Jonathan on these topics from Financial Inclusion Week).
Where does that leave us?
Well, it’s one of the reasons that we are not only visiting firms weekly, but doing so for a full year. We expect that looking at net cash flows over several months is going to be a lot more informative. Do firms that cluster around 0 ever have large spikes or dips? If so, why? If they do, what tools do they use to create or cushion them? Do firms treat stability as a goal or a problem? What other behaviors does net cash flow predict (and what behaviors predict changes in net cash flows?)?
One of the questions we are taking up now is looking at the role that wage payments play in net cash flows. Some firms cut wages (by limiting the hours of workers) as a first line of defense when revenues fall; others continue to pay workers even when there is a substantial revenue dip. Many firms, of both types, advance wages to employees. We want to learn a lot more about the extent to which employees absorb shocks to the firm, and how much owners cushion employees from shocks, or provide a tool to those employees to cushion external shocks to the household.
As always, there’s much more to come. In the meantime, we’ll be taking up some of the questions about volatility, net cash flows, profitability, and employees via another mechanism enabled by financial diaries: short profiles of some of the firms in the study that take into account the qualitative data we gather, not just the quantitative measures.