A dear Big Three consultant friend of mine once told me “you are free to choose any set of buckets and frameworks to understand the inner workings of a business — but at the end of the day, all case studies boil down to a single equation” — behold:
I’ve boxed it twice because it’s just so nice. All businesses are constrained by this fundamental relation — indeed, it’s best to think of this as industry’s version of The Law of Energy Conservation (for reasons we’ll explain below). In this Daily Brief, let’s call this equation the Law of Capital Conservation [[trademark pending]].
To see this in action, let’s take a look at Nvidia’s income statement for Fiscal Year (FY) 2023:
Upon inspection, we can see the statement includes (net) income and revenue — but we are missing the total costs. This is typical of the high-level income statements available on Google and Yahoo Finance (for those interested, I prefer Yahoo over Google because it’s easier to download historical data for my own market analysis in the form of CSV files).
To make sure our Law of Capital Conservation is obeyed (or squares, to use some consulting jargon), let’s take a closer look at the breakdown below:
Now we can see what was missing: in addition to operating expenses/costs (in red), there is also cost of revenue and tax. These two additional contributions factor into other business factors, like EBIT/EBITDA, COGS, SG&A, and more! We will cover all of these at a later date.
For now, let’s simplify this depiction of the income statement to reflect our fundamental Law of Capital Conservation:
I call this simple three-legged diagram the Business Heat Engine, because it plainly shows the core function of a business,
Revenue enters (in exchange for goods and services)
Total costs go out (in exchange for labor, goods and services)
Net Income remains (ready to be deployed by the business for its own use).
and this is just like a real heat engine, in which,
Input Heat goes in (in a disordered state from a heat reservoir)
Exhaust Heat go out (in a disordered state into a heat sink)
Mechanical Energy is extracted (in a useful ordered state to do work).
For the thermo enthusiasts, below is the analogous diagram we are familiar with for heat engines
with thermodynamic Energy Conservation expressed as follows:
So, just to really drive it home, work (W) = income, input heat (QH) = revenue, and exhaust heat (QC) = total costs. With this, one could imagine building a model for the business cycle to compute projected earnings by utilizing the well established integral formula for the work:
What about the Entropy?
The metaphor between businesses / heat engines goes even deeper than just the inputs and outputs of capital / energy.
Consider the entropy (disorder) of the capital used in this process.
The business system has a bunch of clients (either other businesses, B2B, or consumers, B2C) who are disordered relative to the business, and are indifferent to how the business deploys its income. These clients happily provide disordered input capital (revenue) it in return for some good or service (G&S).
So where does the income derive its order?
from the human capital of the its employees, and the G&S of the business’ suppliers.
from the institutional knowledge of the business.
The employees and business suppliers in turn receive salary and payment for their contributions, free to spend their capital in a way randomized relative to the business.
For the business, the remaining income is useful and ordered, and can be deployed however the business sees fit (through further CAPEX, R&D, stock buy-backs, dividends, etc.).
So what is a business?
Businesses are essentially human-level machines for ordering capital, just as heat engines are atomic-scale machines for ordering gaseous particles.
And just like engines, your mileage may vary :)
Looking forward…
Now that we have learned about the high-level function of a business, tomorrow we’ll discuss how to account for all the subcomponents of income statements using a consulting framework known as MECE. Stay tuned!
Hi Nic, what a cool parallel!
One question though:
In a heat engine, input heat generates exhaust and work.
But in a business, it's the cost that generates revenue and income.
Does this difference in causation make a difference when you use the thermodynamic integral formula to build a model for projecting earnings?
(Hope the question isn't dumb. I represent the readers who only hold a bachelor's degree.