One of the fundamental things to understand in any business is how it is going to make money.
One of the fundamental things to understand in any business is how it is going to make money. And while it needs to make money, WHEN it makes money is also important. If it is spending too much before it receives cash, it will quickly be in trouble. It’s a bit like not plugging the drain when filling up a bathtub. It would just keep draining out again.
There are plenty of ways to make money and it is different depending on the type of company. There are (2) main types of companies – Service Companies and Product Companies. There can also be hybrids of these two models, but for now, we’ll talk about them separately.
The easiest way to differentiate between the two is that one offers things that you can experience but not really ‘grab’ onto, and the other provides things you can ‘grab’ or at least virtually grab (in the case of apps on your phone).
Angry Birds is a product. You buy it, and you use it.
Any item you buy in the store (make-up, clothes, etc) is a product.
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There are things you should take into account with both types of companies. For example, a service company is going to rely a lot more on labor (people) rather than inventory (things)since what they are selling is an experience, usually created or produced by people. Whereas a product company may have inventory costs (in the case of a produced good) or upgrade costs to its product (in the case of a digital item like an app).
With a service company, revenues need to outpace the payments to the staff or labor to create and manage the clients. And with a product company, the revenues may lag behind the initial creation of the product, leading to a leveraged or debt position at first but will then start to outpace hard costs to a much greater degree than a service company.
So while a service company may get to positive revenue and cash flow quicker, they may not grow in profits as significantly as a product company. These companies may require a lot of debt upfront to create the product, but then will watch revenue quickly outpace expenses, and be in a much better position later on in their company trajectory.
Either model is good if revenue is strong, trending up, and there is at minimum a current or forecast of positive annual cash flow.
However, knowing that a product company may start more in the red (debt) than a service company is useful information. And knowing that in the long run, product companies may significantly outpace service companies in overall profit margin, is useful as you analyze start-up companies and evaluate their pros and cons.
Article to read:
Analyze Cash Flow the Easy Way – Investopedia