Growth investments: Unlike the sustaining investments, growth investments are investments in new capacity, business areas, or technologies and are directed at increasing the company's rate of Revenue, Net Income, and Cash Flow growth.
Every company needs to make “sustaining investments” to stay alive. Those that don't will go into a period of decline. While it may take many years, decline, if unchecked, is ultimately terminal. Unfortunately, while sustaining investments are necessary, they usually aren't sufficient. This is because growth will ultimately slow down and demand in the company's niche or market will sooner or later stabilize or decline as the market matures. In terms of a company's value, decline is a disaster. As far as investors are concerned, when market growth or sales decline, this is quickly seen in the value of the Company's shares.
In some instances, a decline in cash flow can be avoided by cutting costs. In fact, management can increase cash flow by disinvesting in the business. However, in today's business climate, increasing cash flow by expense control doesn't work for very long. Eventually cost cutting is a dead end and the only remaining road to increasing shareholder value is growth. Growth opportunities don't just come along. A company has to be committed to investing for growth in order to get it and even then success is highly uncertain. Unlike sustaining investments, investments focused on growth inherently involve more risk. The upside is, of course, the possibility of a better return.
Making a choice between sustaining or growth investments or investing for both is not simply a matter of money. In practice it (money) frequently turns out to be the least important resource. Investments directed at growth require ideas and sometimes new technologies. Furthermore, it's not very often that a management team that is outstanding when it comes to cost control and optimizing the productive level of sustaining investments is also good at managing a company for growth. While managing the process and resources associated with putting a company on a growth track can be learned, it takes time – often lots of time and many lessons learned. In practice, most companies make both sustaining and growth investments at the same time. Successful companies have learned that each category of investment has its own prerequisites and culture and therefore staff and manage accordingly.
As far as the Cash Flow Statement is concerned there isn't any need to be concerned with the kind or category of investment but rather how investments are treated financially and the impact investments have on Cash Flow after Investing Activities (CFaIA).
Recalling that earlier in this chapter Equation [1-46] defined Cash Flow from Operating Activities (CFfOA) as:
[1-46]CFfOA = NI + D & A ± ΔWC
and that Cash Flow after Investing Activities (CFaIA) can be expressed as:
[1-47]CFaIA = CFfOA − Investments
substituting [1-46] for CFfOA in [1-47] produces an equation for CFaIA expressed in terms of operating cash flows and investments.
[1-52]CFaIA = NI + D & A ± ΔWC − Investments
Example 1-6: Calculating CFaIA and CGU
Cash Flow after Investing Activities for the company represented by the Cash Flow Statement (Table 1-5) in Year n can be determined by substituting the values for NI, D&A, ΔWC, and Investments in Equation [1-52].
CFaIA = 6,900,000 + 5,000,000 − 1,250,000 − 10,000,000 = $650,000
The CGU is calculated with the use of Equation [1-50]
[1-50]Cash Generated (Used) = CFfOA − Investments ± Financing
− Dividends Paid
Substituting values from Table 1-5 for CFfOA, Investments, Financing, and Dividends Paid the CGU is calculated to be:
Cash Generated (Used) = 10,650,000 − 10,000,000 ± 0 − 0 = $650,000
It may be helpful to look at the Cash Generated/Used from another perspective. Recall that
[1-47]CFaIA = CFfOA − Investments
Rearranging,
[1-53]CFfOA = CFaIA + Investments
Substituting the results of Equation [1-53] for CfaOA in Equation [1-50] yields
[1-54]Cash Generated (Used) = CFaOA + Investments − Investments
± Financing − Dividends Paid
or
[1-55]Cash Generated (Used) = CFaIA ± Financing − Dividends Paid
Substituting,
Cash Generated (Used) = 650,000 ± 0 − 0 = $650,000
It is worthwhile to note that since no Equity was sold to investors and no dividends were paid, the CGU is the same as the Cash Flow after Investing Activities.
So if $650,000 of Cash was generated during this period, the question is: How much cash will the company have at the end of the period? If you assume the Balance Sheet shown in Table 1-3 is the balance sheet at the end of a month (January), then the cash balance at the beginning of the next month (February) will be the same as the cash balance at the end of January, or $750,000. Then if the Cash Flow Statement shown in Table 1-5 is the statement for the month of February, the Cash Generated during February will be $650,000 and the cash balance at the end of February would be as shown in Table 1-6.23
Table 1-6 Period Cash Balances $(000)'s
⧉ Required Revenue for a Given Level of Net Income 24
So far the primary focus has been on Net Income and Cash Flow and what drives them. One issue that hasn't been addressed is the role Revenue plays in covering all the expenses incurred by a business. For example, for any given level of Net Income the Revenue must be adequate to cover the Cost of Goods Sold, Operating Expenses, Depreciation and Amortization, Net Interest, and Taxes. In this section, instead of starting with Revenue, the Income Statement will be worked backward, so to speak, and start with Net Income and end up with the Required Revenue to support the Net Income.
The analysis of Required Revenue begins by referring to Table 1-7 and then letting “RR” represent the Required Revenue to drive a level of Net Income.
Table 1-7 Income Statement for Calculating Required Revenue
By inspection:
[1-56]NI = Rev − COGS − OpExp − D & A ± NetInt − TaxesPaid
or
[1-57]NI
