# How Finance Works **Mihir Desai** | [[Numbers]]  --- > "Two foundations of the finance perspective: cash matters more than profits; and the future matters more than the present." Finance isn't about arcane formulas or clever deal-making. It's about seeing businesses through two simple but profound lenses. The first reframes accounting: profits can be distorted by managerial discretion and noncash expenses, but cash reflects real economic capacity. The second reframes time: value comes from expectations about future cash flows, not historical results. > "Revenue is vanity, result is sanity, and cash is king." --- ## Core Ideas ### [[The Two Foundations of Finance]] **Cash > Profits.** Accounting profits can be manipulated; cash cannot. Your capacity to transform your business into cash—to finance activities, repay debt, or distribute to shareholders—is key. The statement of cash flows is where finance people focus because it looks purely at cash (avoiding the problems of noncash expenses and historical cost accounting). **Future > Past.** Accounting and financial analysis characterise the past and present. Finance professionals look to the future for the most important questions regarding value. Value comes from expectations about future cash flows, not what happened historically. ### [[The Four Ratio Questions]] Ratios are the language of business. They make numbers meaningful by providing comparability. > "Broadly speaking, the ratios deal with four questions: profitability, efficiency, financing, and liquidity." **Profitability**: How is the company doing in terms of generating profits? **Efficiency**: How productive is the company? **Financing**: How does it finance itself? **Liquidity**: Can the company generate cash quickly? **First step when facing a sea of numbers**: Look for extreme numbers, then create a story about them. ### [[ROE and Capital Markets]] Why ROE (Return on Equity) converges across companies: Companies may compete in different product markets, but they all compete in **capital markets**. Returns to shareholders can't deviate too far because capital will be driven away from low performers toward better performers. > "While these companies don't compete in product markets, they all compete in capital markets. Consequently, the rewards to shareholders can't deviate too far from each other because capital will be driven away from low performers toward better performers." **Risk drives returns apart**: If shareholders bear more risk, they demand higher returns. Capital markets and competition drive returns together; risk drives them apart. **The ROE problem**: Leverage can inflate ROE, making poor operational performance look better by forcing owners to bear more risk. That's why some people prefer return on assets or return on capital as cleaner measures. ### [[The Value Creation Imperatives]] **To create value, companies must do three things:** > "To create value, companies must do three things: beat their cost of capital; beat it for many years; and reinvest additional profits at high rates through growth." Beat the cost of capital—if they don't, nothing else matters (competitive advantage through innovation). Beat the cost of capital for many years—sustain the gap (barriers to entry, brands, IP protection). Reinvest additional profits at high rates—grow the opportunity (expansions, adjacencies, integration). These prescriptions correspond directly to business strategy. --- ## Key Insights **Large cash holdings can be insurance during uncertain times, a war chest for acquisitions, or a manifestation of absence of investment opportunities.** The statement of cash flows avoids the problems of the income statement (noncash expenses, managerial discretion) and balance sheet (historical cost accounting, conservatism). **There are only two sources of finance for purchasing assets: lenders and owners.** Debt offers fixed return with priority for repayment. Equity offers residual claim with variable return. The costs of debt and equity differ because of this risk structure. **An investor's expected return becomes the cost of capital for managers.** The costs of capital are a function of the returns that investors expect. Finance is deeply embedded in daily operations, not just in debt and equity decisions. > "An investor's expected return becomes the cost of capital for managers." **Accounting looks backward (characterising past and present). Finance looks forward (to the future for value implications of decisions).** The idea that we should ignore something just because we don't know its precise value makes many finance people distrust accounting. --- ## Connects To - [[Better, Simpler Strategy]] - Cost of capital connects to WTP/WTS; companies must beat cost of capital to create value - [[7 Powers]] - Beating cost of capital for many years equals Power; barriers to entry sustain the gap - [[Everything Is Predictable]] - Bayesian thinking about future cash flows under uncertainty - [[Algorithms to Live By]] - Ratios as a chosen metric ("before you can have a plan, you must choose a metric") - [[Dead Companies Walking]] - Companies that fail to beat their cost of capital eventually collapse --- ## Final Thought Most people think finance is complex; Desai shows it's conceptually simple—cash matters, the future matters, and four ratio questions tell you most of what you need to know. The real power is in the **value creation imperatives**: beat your cost of capital, sustain the gap, reinvest at high rates. This isn't just finance—it's strategy. Companies that fail any of these three tests are destroying value, regardless of what their accounting profits show. The shift from accounting to finance is the shift from looking backward to looking forward. Accounting tells you where you've been; finance tells you where you're going and whether the journey is worth taking. That distinction—between describing the past and creating the future—is everything.