Posts Tagged 'Cash'

September 10, 2007

You Can’t Judge Health by Net Income Alone

In GAAP, net income is the bottom line. It's supposed to tell you if you're making money or losing money. But the amount on the bottom line is never equal to your bank balance and by itself, it's an inadequate measure of a hosting company's health.

For example, depreciation is subtracted before you arrive at net income. But depreciation is not cash going out the door. It represents the theoretical drop in book-value of something you own, such as servers. Ideally, the timing of depreciation should match the length of time you actually use something, so if you use a server for three years, its value would depreciate to zero over three years.

Problem is, from the years of hosting experience we have in this company, we know that servers bought in the early 2000's are still in use today. Many were depreciated over three years, but they're still generating sales revenue long after they've been depreciated to a value of $0. What this means is that net income from these servers was effectively UNDERSTATED during their first three years of use and that net income is currently OVERSTATED for the periods of use after their value has dropped to $0 on the books.

But since I have to judge a hosting company's health based on Net Income, here's how I do it. If net income is positive and it's greater than depreciation expense, one of two things is going on. Either they're knocking it out of the park in this asset-intensive business or they're not reinvesting enough to remain technologically relevant. If net income is positive but less than depreciation expense, they're likely healthy. If net income is negative and the absolute value of depreciation expense is greater than the absolute value of net income, the company could be fundamentally sound and worthy of receiving credit. Bankers will likely disagree with me, but my opinion here is hosting-business specific. Finally, if net income is negative and the absolute value of net income is greater than the absolute value of depreciation expense, then the company needs to adjust something to get healthy.

If you ask me, cash generation from operations is a much better indicator of the health of a hosting company. It ignores distortions like this mismatched depreciation. It will also tell you if the company generates enough cash to cover its debt service and/or to continue investing to stay technologically relevant.

Got that? If I haven't lost you already, I'll talk about how the normal Current Ratio calculation unfairly penalizes hosting companies next time.

-Gary

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