cash cycle - bfa.docx

Cash Cycle In this module, we're going to talk about the cash cycle, or what's also called the cash flow cycle of a business. This will help us better understand the business model, or how a company generates cash on a recurring basis, so that we can understand better the two questions that investor...

Cash Cycle In this module, we're going to talk about the cash cycle, or what's also called the cash flow cycle of a business. This will help us better understand the business model, or how a company generates cash on a recurring basis, so that we can understand better the two questions that investors are going to ask us relative to value creation. Let's talk first about the cash cycle. Every company, every project goes through what's called four stages of a cash cycle. The first stage is known as financing. Generally, we have to do the work before we get paid, which means we have to have the cash to have the resources to do that work. So, the first thing we have to do is we have to raise that cash through financing. That generally means we go out and we borrow debt from either a bank or a bond holder, or we borrow equity from a shareholder, whether it be common or preferred. That is what's going to allow us to finance the business. We then take that cash in stage one, and we move to stage two, which is known as the investment stage of the cash cycle. We basically go shopping. We buy what's called assets. We buy infrastructure. We buy buildings. We buy land. We buy equipment. We buy IT systems. We might hire staff. We might get some inventory. We're basically getting a product or service ready to be sold. It's important to understand that at this stage of the cash cycle, we haven't sold anything and we haven't really generated any cash from customers. So, we're just spending the money that we had raised. Now, once our product or service is done and we sell it to a customer, and we invoice and get paid, we then move to stage three of the cash cycle, which is known as operations. At this point, we have sales or revenue, we have cash coming in, and we probably have some additional operating expenses. We spend it on marketing. We spend it on overhead. We then determine whether or not we have a profit. We take all of our sales, subtract out all of our expenses, and hopefully we generated a profit, also known as income. We then take this profit or income, and we then go to stage four and we start returning the cash back to the investors. We pay interest to the banks and the bond holders. We pay dividends to the preferred and the common shareholders. We might also choose to repurchase some of our stock as a cash flow paid out to a shareholder. That completes the cash cycle. And then we have to make a choice. Do we take all the cash and do we pay it out, or do we take some of the cash and do we reinvest it to try and do more cash cycles for the business in the future? That's what's going to be key to the question of value creation. Because if you think about it from an investor standpoint, we're going to apply our questions for value to the cash cycle. What are they going to ask? Question number one, if I put a dollar of financing into the business at the financing stage, does more than a dollar come out at operating stage to be able to pay back the investors? If the answer to that question is no, then you don't have to really worry about the second question. That's going to be key to value creation. Question number two, assuming you generated more than a dollar, was it enough to compensate for the risk? Assuming that was, then we assume that you're going to create value. To answer those two questions, we have to measure the progress of the cash cycle. When we start a project it's easy to understand the four stages of the cash cycle because we typically go through them sequentially. For an existing business it's typically not as sequential. Existing companies go through all of the stages of the cash cycle every day. That's where financial statements come in. The balance sheet, which we're going to talk about in a different module, focuses on the first two parts of the cash cycle. It measures the financing, where the cash came from, and it measures the investing, where the cash was spent on the assets. We then also measure the operating stage to see if we're generating more cash than we spend by looking at what's called the income statement, or P&L, profit and loss statement, to see if we're making or losing money. The financial statements give us a sense of progress that we're making on the cash cycle to track internally and to report out to investors. Ultimately, we can use this information to make choices with the profits we make to decide if they are good enough and if it is worth reinvesting. Let me talk about that final choice. Do I want to take the money and reinvest it? And what's going to drive that choice? Well, that's going to go back to the concept of spread. If I think that I can get a good spread, which means I can get a good return on my investment by running through the cycle, and I can compensate myself for the risk that I take, then I'm going to probably want to reinvest the cash. If I don't, then I'm probably going to want to pay out the cash to avoid the negative spread or poor performing investments. So, my ability to understand my performance and to be able to make that decision is going to be critical to the value creation. Therefore, the cash cycle really helps me understand what's happening in a business. It tells me about the four stages of the cash. It tells me about the financing. It tells me about the investing. It tells me about the operating. It tells me about the ability to return. And it helps me with my decision-making to decide whether or not it's worth reinvesting for future cycles to create value. There is one other element to the cash cycle. Completing the cash cycle tells us how much cash we generate on our investment when we run it through the business. But as a sub question we can also measure how long it takes to turn a dollar of investment into a dollar of collected cash. This is a metric called financial cycle time or FCT. Financial cycle time Is measured in days. To estimate FCT you need two pieces of information. You need the total invested capital that's tied up in the business which can be found on the balance sheet. You also need 12 months worth of annual sales or revenue. If you take the invested capital and divide by the sales or revenue that will tell you the percentage of a year it takes to sell that investment. If you then multiply by 365 that will get you the days of cycle time. The point here is that the longer our cycles the more cash that will be tied up with the business. The shorter our cycles the less cash is tied up with the business. The other insight is that financing is really about time. Have you ever wondered why a profitable company borrows money? Think about it if I generate more cash that I spend - I have profit - why would I need to borrow money? The answer is in the cycle time. There's a timing difference between the time I borrowed the money, the time I invest in my business and the time that I get repaid in operations. The longer that cycle time the more cash that gets tied up in the business. This is another key point of the cash cycle. Companies with shorter cycle times that do not compromise quality or safety can tie up less cash while at the same time be more efficient and flexible at delivering products and services to customers.