So there’s a disconnect, or rather, a difference of opinion about what makes capitalism work. One one hand you have businesses that run their entire business on credit and/or investor cash. On the other hand, you have businesses that run off of sales of goods and profit margins.
Allow me to elaborate.
Despite what Dave Ramsey says, not all credit is evil. Let’s say you start a business baking delicious brownies in your oven at home. You sell these brownies at a stand each weekend at a local flea market. It’s a pretty consistent side business, where you buy $100 worth of groceries, make several dozen brownies and sell most of them each weekend, and for sake of argument, let’s say your weekly profit is about $100.
But then one day, someone tries your brownies at your stand, loves them and offers to put them in their 20 grocery stores right away. Great, huh? Your little $400 a month business just turned into an actual company. Instead of selling a few dozen brownies a week, you can sell dozens every day.
Except that the initial ingredients and packaging for the brownies for this huge order is far more than $100. Let’s say the initial order is two dozen per store, and each store anticipates ordering three times a week AND the store wants 30 days to pay for the brownies. You need somewhere in the neighborhood of $1,500 or more per week just to make this deal work. So your expenses just went from $400 a month to $6,000, and you’ll probably need to lay out somewhere around $30,000 before you see a dime of profit.
Where is the cash going to come from to make this deal work?
This is the basic concept behind how businesses can use credit to grow. They borrow the money for goods (or use credit terms like Net 30, which means the payment for the products isn’t due for 30 days), sell the goods before the bill is due and then pay the bill out of the profits. This is how places like Wal-Mart and Home Depot operate. It allows businesses to sell as much as they can without outlaying all of the cash at once. This is a simplified explanation, but that’s basically it.
Now, let’s talk about another type of business run on credit. This can take many forms, but the most glaring is the ‘dot-com’ mentality of financing a company and trying to buy into a market. Let’s say that instead of baking brownies and selling them on the weekends, you come up with a great idea to allow people to order brownies from bakeries all over the world from a new website. In order to do this, you need accountants, programmers, and marketing people. In order to pay for all of those people, you need investors and hopefully credit from banks. So investors want to see corporate officers, financing, etc. (more money you’ll need). And in order for all of this to pay off, you have to make big media buys to grab ‘brand recognition’. I’m going to skip over a lot of nonsense that happens in these ‘businesses’, but basically, it boils down to millions of dollars being spent without any, or much revenue. What’s worse is that usually the people who run these businesses have never actually, well, made a profit. Their mentality is that they will burn through cash until the company becomes so big and has so much market share it will become profitable. Or, the idea is that if the company seems viable enough, some other bigger company will buy it and everyone will cash out.
So when the credit markets recently dried up, it hammered these propped up businesses that had no idea how to, well, actually be in business. It’s easy to spend money, but hard to make a profit with good, remarkable products and services. Wal-Mart’s sales might have dropped but nobody is pulling Wal-Mart’s Net 30 agreements. Wal-Mart will still be able to put products on the shelves.
One of the issues I have with the second business model is that it creates an environment of so-called business ‘experts’ who litter the airwaves of CNBC and Fox Business who have never actually made a profit in anything. They drive expensive cars paid for with venture capital, fly to business conferences and symposiums for ‘group think’ and talk about government fiscal policy like they are economists.
It’s not that a real business can’t be started purely on credit, but almost all of these businesses crash and burn, and a lot of these ‘business people’ who were driving their credit-based companies into complete financial ruin get high paying jobs in real companies – like banks – and proceed to make the same choices they did before. Of course they wouldn’t learn from their mistakes – from their perspective, they haven’t made any mistakes. It doesn’t matter that their brownie-ordering web based site never made a dime of profit, all that matters is that they made $350,000 for three years before selling the company to a big food conglomerate and cashed out for $3,000,000.
So, here’s where we are, today. Who are you going to listen to?