Profit margins and cash flow are frequently central to evaluating a company’s financial health. Yet, our experience indicates that management often prioritizes profits without placing enough emphasis on cash flow. This oversight can be critical; businesses more commonly falter due to a lack of liquidity than to inadequate profits. Amazon provides a notable example of how leveraging cash flow, despite low profit margins, can fuel expansive growth and innovation.
Amazon has chosen not to maximize its margins but rather to generate positive cash flow by quickly collecting payments from customers and deferring payments to suppliers. Effectively, Amazon has turned its suppliers into inventory financiers at zero percent interest. This strategy has enabled Amazon to quickly reinvest in its business, reducing reliance on external financing. Crucially, by favoring volume over margin, the company has achieved economies of scale more rapidly than if it had sought to generate high-margin but low-volume sales.
In contrast, certain companies focus on preserving high profit margins, as is typical in sectors like luxury goods or specialized technology, where they can leverage strong pricing power. Although these firms may report higher profitability per transaction, they may not manage cash flow as effectively. This can become a weakness, especially as new competitors often challenge the market on price, potentially eroding industry-wide profits.
The ideal scenario, of course, is to be able to balance attention to both cash flow and profit margins. Walmart is one company that seems to have done a commendable job in this area. By leveraging its massive scale, Walmart achieves low prices and thin margins but compensates with a high volume of sales and efficient inventory turnover. This approach not only sustains its cash flow but also supports steady growth and investment in innovation. Apple is another example. Through its premium offerings and direct-to-consumer business model, the company can sell its products and collect payments from customers quickly, minimizing working capital needs. Meanwhile, its negotiation power and scale enable it to manage payable terms effectively with suppliers.
While not every business has the luxury of being able to focus on both cash flows and margins, we believe that prioritizing cash flow over profits is a sound strategy. Cash flows not only enable a business to sustain operations but also give it time to fine-tune pricing and cost structures that are sustainable. More importantly, sacrificing margins for cash flows can help drive product velocity and expedite the path to achieving economies of scale.
