I recently covered the challenges of managing negative cash flows. Breaking through the cash flow break even barrier is a completely different matter. Start ups seem to reach this point and never leave it, a gravitational black hole not unlike the friend zone. Understanding this statistical anomaly requires a mix of finance and psychology.

The first issue is getting a better understanding of what cash flow break even might mean. The conventional cash flow statement is formed from three main flows. Briefly, cash flow from operations is cash from the core business of producing and selling goods and services. Cash flow from investing is basically capital expenditure, buying and selling property, equity, machinery, etc., as well as long term investments. The third cash flow is from financing such as selling equity in the company or getting a loan from a bank.

It is clear that the most important cash flow is from operations as it tells you if the business is covering its cash from its core business. Looking at total cash flow, i.e. how much cash is in the company’s bank account, distorts the picture as an all too common mistake is to believe that cash flow from financing is a viable long term option.

Even when focussing on operating cash flow, one cannot do so blindly. The working capital of the company, a measure of its short term liquidity position, can also distort the picture. The usual method is by increasing accounts payable, i.e. delaying payments to suppliers, whilst holding accounts receivable steady, i.e. demand that customers continue to pay in a relatively short time period.

The trap with playing this working capital game is twofold. The first is that it only works for as long as the business is expanding quickly. Once this initial period ends, then the benefits of this cash management hack ends. The second issue is that it upsets, to put it mildly, the suppliers.

Another trap that leads companies to fall into the break even zone is misunderstanding the operating margin which relates to the income statement (profit) as opposed to cash flow, but there is still a strong connection. Operating margin is the ratio of profit to revenues, or more generally how much of each dirham in sales makes it to profit.

During the initial loss making period, a start up will have a negative operating margin. As the operating margin improves and goes from negative to positive the company becomes profitable and cash flow will usually improve commensurately. The problem can be clarified by understanding that operating margin can be decomposed into fixed cost, e.g. buildings, IT systems, and executive management, and variable cost and revenue.

As an example, consider a company with AED 10 million fixed cost. This company also generates AED 1 for every AED 1 spent on variable cost. In the early stages of the start up it might spend AED 1 million in variable cost to generate AED 1 million in revenue for a net loss of AED 10 million and an operating margin of -10. The company spends more, say AED 10 million, and therefore generates revenue of AED 10 million, loss of AED 10 million and operating margin of -1.

What a wonderful improvement in operating margin! But wait, what if the company spends AED 50 million? Operating margin improves to -0.2 but still is not positive. Spend a billion? Operating margin is -0.01. No matter how much this company expands, it is driving margin improvements by expense expansion and will never become profitable. This tragedy when it plays out in multi-nationals or even larger institutions leads to billions being wasted chasing a financial mirage.

The psychological part of the analysis has to do with the human bias to overweight nearby risks over risks that are further out. Sometimes this bias is useful, but when the risks are inter-related then it is can be extremely dangerous.

A race to cash flow break even will usually lead to decisions that stop the company from being able to grow positive cash flow. A simple example is the above: a marginal profit of zero can be useful to reach cash flow break even, but is useless in moving past it.

Positive cash flow growth simply is not a linear extension of break even.

This article was originally published in The National.