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Cash Flow Analysis
- The effects
of growth on
cash flow and earnings
- How free cash flow
benefits investors
- Don’t blame EBITDA for
your losses
- The borrowing base
impacts cash flow and equity
- The debt repayment
schedule can predict a
liquidity crisis
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The effects of growth on cash flow and earnings
Growth doesn’t just happen, it’s planned for. When
executed, growth drains cash flow and hurts short-term earnings.
Shareholders pay the cost for growth; in return, they expect increased
profits, cash flow and share value as compensation.
A good way for investors to appreciate the impact of
growth on shareholder wealth is to consider the effect of hiring just one
salesperson. When hiring a salesperson, the company would have an initial
cash outflow in terms of base salary, possible a draw on future commissions,
medical insurance, rent on office space, telephone costs, car expenses, etc.
When the salesperson’s orders first come in, initial processing costs will
probably be high, and the gross margin on the sales low. It can easily take
a ramp-up of six months before his/her sales volume breaks even. Many times,
it takes a year before the salesperson’s cumulative losses are covered by
the profits from sales. In reality, depending on the company, it may take
that salesperson one to two years before the company starts to make any
money on him/her. The up-front costs are all paid for by the stockholders.
This is the price of growth. Next year’s profits are based on this year’s
actions.
The critical issue when a company develops a new
product or is growing internally is: how are the cash outflows and expenses
funded? In most circumstances, this lone salesperson’s expenses get
commingled with the rest of the employees. While most employees in the firm
probably are not concerned with the nuances of growing, the shareholders
should be. They are footing the bill. This example is just focusing on one
person. In many organizations, however, more people are usually involved in
growth initiatives, and the process encompasses investment in PP&E, R&D,
sales and operating departments. The concepts, nonetheless, are the same.
Equity dollars are mainly used to fund these costs, until sales and profits
ramp-up to breakeven, and then to cover the initial cumulative losses of the
project.
Banks don’t normally fund start-up expenses. In many
large organizations these expenses are funded by the income of the company.
It’s important to remember that the profits of a company belong to the
shareholders and thus affect the stock price. Meeting Wall Street’s
quarter-to-quarter earnings comparisons and “street” estimates can hinder
internal growth prospects. Some companies take a different route to growth;
they choose to buy established products at higher costs, in order to forgo
the initial cash drain, expenses and risks associated with internal
growth.
Investors need to determine if their company is
investing for the future through internal projects, which usually drain cash
and earnings as they are being developed, or if they are growing through
acquisitions. GE is a good example of a company that has been successful at
buying its growth; their sales force is their acquisition team. They are
buying customers and product lines; everything else usually gets integrated
into the GE machine.
Some industries make equity investments in smaller
companies, then set up licensing arrangements to purchase the product, once
it has been developed and produced. This allows larger companies to acquire
a steady stream of growth, products, and talent, without disturbing the
finances or personnel of their main organization.
Regarding individual investors, internal growth is
reflected in operating cash flow, while purchased growth shows up as
investing cash flow (acquisitions).
When companies are on a “hiring binge,” there’s an
initial ramp up cost that “hits” earnings and cash flow prior to GAAP
earning improvements. This time lag can present a widow of opportunity for
potential investors.
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