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additional expenses

× 11⁄12 = $59,583 cash outlay).

Summing Up the Cash Flow Effects

The differences between cash flows and the accrual-basis amounts of changes in sales revenue and expenses for the year caused by increasing sales volume are summarized as follows:

• There is a one-month lag in collecting sales revenue TEAMFLY

because the business sells on credit, so only 11⁄12 of the increase in sales revenue is collected in cash through the end of the year.

• The sales volume increase requires a corresponding increase in inventories that is equal to two months, or 2⁄12, of the cost-of-goods-sold increase; accounts payable for invento-

ries also increase, equal to one month of the increase in inventories. So the cash outlay for the inventories increase is only 1⁄12 of the cost of goods sold increase.

• There is a one-month lag in paying variable operating expenses, so only 11⁄12 of the increase in operating expenses is paid in cash through the end of the year.

Basically there is a one-month time differential between the accrual-basis changes in sales revenue and expenses and the cash flows in from sales and out for expenses. There is a
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P R O F I T G U S H E S : C A S H F L O W T R I C K L E S ?

one-month cash flow delay from the sales revenue increase, a one-month additional cash outlay for the cost of goods sold increase, and a one-month delay in paying the variable expenses increase. This one-month shift is fairly realistic for many businesses; it certainly moves the accrual-basis numbers much closer to when actual cash flows occur.

CASH FLOWS ACROSS DIFFERENT PRODUCT LINES

Figure 13.2 presents the cash flow effects from increasing sales volume 10 percent for the three product lines of the business. I’d wager that the cash flow effects, especially for the generic product line, surprise you. If not, you’d better take a closer look at Figure 13.2.

The best cash flow result is for the premier product line, but even here the cash flow increase for the year would be only $162,500 compared with the $250,000 profit increase.

For the standard product line, the cash flow yield is only $75,000 for a $200,000 gain in profit, and cash flow actually decreases $5,000 for the generic product line, even though profit increases $150,000.

For each of the product lines, the delay in collecting the increase in sales revenue combined with the cash outlay for increasing inventories puts a double whammy on cash flow.

The slim margin on the generic products means that the cost of goods sold is a relatively high proportion of sales revenue.

So the increase in inventories puts a particularly large demand on cash to be invested in inventories at the higher sales volume level. The premier product is just the reverse. The high margin on these products means that the increase in inventories does not do as much damage to cash flow.

CASH FLOW FROM BUMPING UP SALES PRICES

Chapter 10 examines the profit effects from increasing sales prices, holding all other profit factors constant. The profit gains are much more favorable compared with increasing sales volume the same percent, as explained in Chapter 10.

The cash flow effects of a 10 percent sales price increase are also much more favorable. Figure 13.3 presents the cash flow effects from increasing sales prices 10 percent for the three product lines. The one-month shift for cash flows explained
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P R O F I T A N D C A S H F L O W A N A L Y S I S

Standard Product Line

Changes

Cash Flows

Sales revenue

$1,000,000

$ 916,667

Cost of goods sold

$ 650,000

$ 704,167

Gross margin

$ 350,000

$ 212,500

Revenue-driven expenses @ 8.5%

$

85,000

$

77,917

Unit-driven expenses

$

65,000

$

59,583

Contribution margin

$ 200,000

$

75,000

Fixed operating expenses

$

0

$

0

Profit

$ 200,000

$

75,000

Generic Product Line

Changes

Cash Flows

Sales revenue

$1,125,000

$1,031,250

Cost of goods sold

$ 855,000

$ 926,250

Gross margin

$ 270,000

$ 105,000

Revenue-driven expenses @ 4.0%

$

45,000

$

41,250

Unit-driven expenses

$

75,000

$

68,750

Contribution margin

$ 150,000

($

5,000)

Fixed operating expenses

$

0

$

0

Profit

$ 150,000

($

5,000)

Premier Product Line

Changes

Cash Flows

Sales revenue

$ 750,000

$ 687,500

Cost of goods sold

$ 400,000

$ 433,333

Gross margin

$ 350,000

$ 254,167

Revenue-driven expenses @ 7.5%

$

56,250

$

51,563

Unit-driven expenses

$

43,750

$

40,104

Contribution margin

$ 250,000

$ 162,500

Fixed operating expenses

$

0

$

0

Profit

$ 250,000

$ 162,500

FIGURE 13.2
Changes in operating cash flow from increases in sales volume.

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P R O F I T G U S H E S : C A S H F L O W T R I C K L E S ?

Standard Product Line

Changes

Cash Flows

Sales revenue

$1,000,000

$ 916,667

Cost of goods sold

$

0

$

0

Gross margin

$1,000,000

$ 916,667

Revenue-driven expenses @ 8.5%

$

85,000

$

77,917

Unit-driven expenses

$

0

$

0

Contribution margin

$ 915,000

$ 838,750

Fixed operating expenses

$

0

$

0

Profit

$ 915,000

$ 838,750

Generic Product Line

Changes

Cash Flows

Sales revenue

$1,125,000

$1,031,250

Cost of goods sold

$

0

$

0

Gross margin

$1,125,000

$1,031,250

Revenue-driven expenses @ 4.0%

$

45,000

$

41,250

Unit-driven expenses

$

0

$

0

Contribution margin

$1,080,000

$ 990,000

Fixed operating expenses

$

0

$

0

Profit

$1,080,000

$ 990,000

Premier Product Line

Changes

Cash Flows

Sales revenue

$ 750,000

$ 687,500

Cost of goods sold

$

0

$

0

Gross margin

$ 750,000

$ 687,500

Revenue-driven expenses @ 7.5%

$

56,250

$

51,563

Unit-driven expenses

$

0

$

0

Contribution margin

$ 693,750

$ 635,938

Fixed operating expenses

$

0

$

0

Profit

$ 693,750

$ 635,938

FIGURE 13.3
Changes in operating cash flow from increases in sales prices
(data from Figure 10.1).

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P R O F I T A N D C A S H F L O W A N A L Y S I S

earlier for the sales volume scenario is adopted here for the sales price increase scenario.

The cash flow effects are much more favorable for the sales price increase scenario than the sales volume scenario. For each of the three product lines, the increase in cash flow from profit due to the higher sales prices is a very large percent of the increase in profit. This is much better than in the sales volume increase scenario. The much more favorable cash flow effect is due to the difference in the inventories factor. In the sales price increase scenarios, the business does not have to increase inventories of products and thus avoids the drag on cash flow that this causes.

A word of caution is in order. Raising sales prices 10 per-DANGER!

cent looks good on paper compared with increasing sales volume 10 percent. But bumping up sales prices 10 percent in a competitive market, or in most markets for that matter, may not be possible. Customers may flock to your competitors, of course, or demand may decrease at the higher prices.

But, having said this, businesses can often sneak in minor increases without drawing attention to the higher sales prices.

Even relatively small sales price increases can improve profit more effectively than much larger increases in sales volume.

And profit increases from higher sales prices have much better cash flow effects.

s

END POINT

Improving profit performance is a relentless pressure on business managers. The preceding four chapters analyze the profit effects from changes in the key factors that drive profit—sales volume, sales price, variable operating expenses, and fixed expenses. This chapter shifts attention to changes in cash flow driven by changes in profit factors. Managers must keep in mind that profit is an accrual-basis accounting number and not a cash flow number. The actual cash flow increase during the period from improving profit can be, and usually is, significantly different than the gain in profit. Indeed, the chapter demonstrates that in certain situations the cash flow effect can be negative from increasing profit. Managers need a good handle on both the profit effect and the cash flow effect from changing profit factors.

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P A R T 4

Capital

Investment

Analysis

C H A P T E R 14

1

Determining

Investment Returns

Needed

TThis chapter explains how the cost of capital is factored into the analysis of business investments to determine the future returns needed from an investment. An investment has to pay its way. The future returns from an investment should recover the capital put into the investment and provide for the cost of capital during each period along the way. The future returns should do at least this much. If not, the investment will turn out to be a poor decision; the capital should have been invested elsewhere.

The analysis in this chapter is math-free. No mathematical equations or formulas are involved. I use a computer spreadsheet model to illustrate the analysis and to do the calculations.

The main example in the chapter provides a general-purpose template that can be easily copied by anyone familiar with a spreadsheet program. However, you don’t have to know anything about using spreadsheets to follow the analysis.

A BUSINESS AS AN ONGOING

A

Remember
INVESTMENT PROJECT

Chapter 5 explains that a business needs a portfolio of assets to carry on its profit-making operations. For the capital needed to invest in its assets, a business raises money
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C A P I T A L I N V E S T M E N T A N A L Y S I S

from its owners, retains all or part of its annual earnings, and borrows money. The combination of these three sources constitutes the capital structure, or capitalization, of a business.

Taken together, the first two capital sources are called
owners’

equity,
or just
equity
for short. Borrowed money is referred to as
debt.
Interest is paid on debt, as you know. Its shareowners expect a business to earn an annual return on their equity at least equal to, and preferably higher than, what they could earn on alternative investment opportunities for their capital.

COST OF CAPITAL

A business’s earnings before interest and income tax (EBIT) for a period needs to be sufficient to do three things: (1) pay interest on its debt, (2) pay income tax, and (3) leave residual net income that satisfies the shareowners of the business. Based on the total amount of capital invested in its assets and its capital structure, a business determines its EBIT goal for the year. For instance, a business may establish an annual EBIT goal equal to 20 percent of the total capital invested in its assets. This rate is referred to as its
cost of
capital.

The annual cost-of-capital rate for most businesses is in the range of 15 to 25 percent, although there is no hard-and-fast standard that applies to all businesses. The cost-of-capital rate depends heavily on the target rate for net income on its owners’ equity adopted by a business. The interest rate on a business’s debt is definite, and its income tax rate is fairly definite.

On the other hand, the rate of net income set by a business as its goal to earn on owners’ equity is not definite. A business may adopt a rather modest or a more aggressive benchmark for earnings on its equity capital.

Of course, a business may fall short of its cost-of-capital DANGER!

goal. Its actual EBIT for the year may be enough to pay its interest and income tax, but its residual net income may be less than the business should earn on its owners’ equity for the year. For that matter, a business may suffer an operating loss and not even cover its interest obligation for the year. One reason for reporting financial statements to outside shareowners and lenders is to provide them with information so they can determine how the business is performing as an investor, or user of capital.