Why to keep a cash cushion and avoid heavy debt

1 The bottom line

Keep enough cash and little enough debt that a downturn leaves you standing while rivals sell. Reserves let you buy when others must sell, and debt turns a bad year into a forced sale.

2 Key takeaways

• Size your cash to survive a full year with no revenue. A cushion that long buys time to act instead of react.
  • Bill Gates, Microsoft1:04:37 never needed venture capital, and in 1997 the IPO money was still in the bank with about $5 billion more.
• Fund growth from earnings, not from borrowing. Firms without debt struggled but survived when indebted firms were foreclosed.
  • David Packard, Hewlett-Packard34:44 found reinvested profits could finance 100% growth a year, and kept the policy for more than half a century.
  • Herb Kelleher, Southwest Airlines26:27 paid for 80% of its planes out of earnings.
• Heavy debt takes away your freedom to take risks. Servicing debt leaves no room to innovate, and a failed bet then forces a sale.
  • The original Starbucks bought Peet's at a debt to equity ratio above six to one, and Howard Schultz, Starbucks40:20 later ran with no debt the entire time.
  • Walt Disney, The Walt Disney Company2:02:55 was $8 million in the hole in 1940 and sold 30% of the company after Pinocchio lost over $1 million.
• Use the cushion to buy when others have to sell. A downturn only becomes an opportunity if you still have money.
  • John D. Rockefeller, Standard Oil26:25 won many bidding contests simply because his war chest was deeper.
• Do not use borrowed money to hide a badly run business. Money cannot cure trouble inside the company.
  • Henry Ford, Ford Motor Company58:36 said you might as well borrow 100,000 lathes as $100,000 if the trouble is inside.

I always wanted to have enough money in the bank so that if nobody paid us for a year, we would be okay.

Bill Gates, Microsoft

2.1 Size the cushion to your worst year

Decide how long you could last with no income, and build to that number before you spend on anything else.

• Set the reserve at one year of survival with zero revenue, as Bill Gates, Microsoft1:04:37 did.
  • Run lean, with no unnecessary overhead or extravagant spending, as Gates1:04:37 did.
  • By 1997 the IPO money was untouched, with about $5 billion more beside it Gates, Microsoft1:04:37.
• Write cost control into the first plan and police it from day one.
  • Gates opened Microsoft's seven page plan with the principle of not getting ahead of themselves and drowning in costs Bill Gates, Microsoft31:58.
  • He wrote to his co-founders about $14,000 spent since he left, and complained they had no company credit card in place Gates, Microsoft31:58.
  • He had watched CCubed go from startup to repossessed furniture in 18 months Gates, Microsoft31:58.
• Collect what customers owe you, because unpaid sales are a hidden drain on cash.
  • Soichiro Honda, Honda Motor Company26:30 sold motorcycles to shops on credit, and many never paid or went out of business.
  • The company faced bankruptcy, which led him to seek a partner strong in finance. He said, "I was not paying much attention to profits" Honda26:30.
• Do not mistake a boom for skill.
  • Ray Kroc's father kept pyramiding land holdings in the 1920s and missed the warnings of the crash Ray Kroc, McDonald's12:55.
  • He died in 1930 holding deeds he could not sell, with a garnishment notice for his entire wages Kroc, McDonald's12:55.

2.2 Fund growth from earnings

Growth paid for by profit leaves no lender able to call your loan in a bad year.

• Go pay as you go, as Hewlett-Packard did.
  • Packard helped his father, a bankruptcy referee, look up failed companies. Firms that had mortgaged assets were foreclosed on and left with nothing David Packard, Hewlett-Packard34:44.
  • Firms that avoided debt struggled but survived, so he and Hewlett financed growth primarily out of earnings Packard, HP34:44.
  • They found they could finance 100% growth a year just by reinvesting profits, and kept the policy for more than half a century Packard, HP34:44.
• Be bold in marketing and conservative in finance.
  • Kelleher studied airline history. Most airlines gave back all their good-time profits in a downturn, and debt payments pushed them in and out of bankruptcy Herb Kelleher, Southwest Airlines26:27.
  • Southwest paid for 80% of its planes out of earnings and owned more planes outright than any other airline Kelleher, Southwest26:27.
• Fix waste inside the business before you borrow.
  • Ford held that borrowing becomes an excuse for not looking into the trouble, and that needed financing often comes from eliminating waste Henry Ford, Ford Motor Company58:36.
  • His own business threw off so much cash that he said Ford did not need any money Ford58:36.

2.3 Keep debt low enough to stay free to act

Debt payments are fixed claims on your cash, and they decide what you can try.

• Avoid a debt load that locks you into servicing it.
  • The original Starbucks bought Peet's with a debt to equity ratio above six to one, which left no room to take risk or innovate Howard Schultz, Starbucks40:20.
  • Schultz grew up with bill collectors always calling, and ran the combined company with no debt the entire time Schultz, Starbucks40:20.
  • The original owners sold the company for $3.8 million in 1987 after the Peet's deal strained their finances Schultz, Starbucks40:20.
• Do not stack several big bets on borrowed money at once.
  • After Snow White, Walt built the $3 million Burbank studio and put Pinocchio, Bambi and Fantasia into production at once. He was $8 million in the hole, with Bank of America lending $4.5 million of it Walt Disney, The Walt Disney Company2:02:55.
  • World War II closed Europe and Pinocchio lost over $1 million. The company sold 30% in a $3.875 million convertible preferred offering in April 1940 Disney2:02:55.
  • Fantasia earned back only $325,000 of a $2.3 million budget in its first year, and Henry Ford told Walt the sale was a half measure: "if you sold any of it, you should have sold all of it" Disney2:02:55.
• If you must borrow, keep a lender who believes in your assets.
  • When Honda could not pay for his imported tools, a supporter inside Kawaraha argued against foreclosure because the equipment was excellent and resellable Soichiro Honda, Honda Motor Company33:30.
  • Honda squeaked through after 6 months and stayed with that small bank even when much larger options existed Honda33:30.

2.4 Turn the cushion into offense

The point of reserves is not safety alone. It is being the buyer when rivals are forced to sell.

• Pay out little and keep the rest in the business.
  • Standard Oil paid only a fraction of profits as dividends to its five stockholders John D. Rockefeller, Standard Oil26:25.
  • Boom or bust, Rockefeller had reserves to buy when others had to sell Rockefeller26:25.
  • He won many bidding contests simply because his war chest was deeper. As Titan puts it, "He always moved into battle backed by abundant cash" Rockefeller26:25.
• Plow earnings into the newest equipment and your own raw materials.
  • Carnegie bought the newest technology every time, and bought Frick Coke and vast Lake Superior ore reserves to control supply Andrew Carnegie, Carnegie Steel38:49.
  • For 25 years he plowed earnings into bigger plants while other firms cruised after their founders got comfortable Carnegie38:49.
  • When prices fell, Carnegie Steel's losses were the least of its rivals, while British steel coasted after the 1880s rail boom Carnegie38:49.

2.5 Where they differ

Maxed-out debt can work for a fast-growing business, but it is a bet that survivors tend to overstate.

• Phil Knight ran the opposite way and still built Nike.
  • Oregon banks lent only up to the book value of the company, so Knight borrowed to the limit and bought inventory with every dollar, running Blue Ribbon at a near 100% debt to assets ratio Phil Knight, Nike55:56.
  • He had to sell fast to repay the bank and ask for the next loan, so "it's growth as a necessity" Knight, Nike55:56.
  • Sales doubled from $8,000 in 1964 to $16,000 in 1965 and kept roughly doubling, reaching $150 million in 1979 Knight, Nike55:56.
  • The hosts warn of survivorship bias, since many companies maxed out debt and died Nike55:56.