Every business has to generate cash flow. It is a fundamental tenet of every business that a business without cash flow will die, even if it is tons of profits. Cash flow is its lifeblood, which is why a business must always seek to ensure that there is a healthy cash flow, amongst the other insane things to keep the business going. Koller, Dobbs and Huyett (2011) gave 4 cornerstones of corporate finance to buttress an executive’s understanding of value add:
1. Companies create value by investing capital from investors to generate future cash flows at rates of return exceeding the cost of that capital.
2. Value is created for shareholders when companies generate higher cash flows, not by rearranging investors’ claims on those cash flows. Don’t substitute debt for equity or issue debt to repurchase shares. It merely changes the ownership of claims to cash flows, but does not change anything about the total available cash flows or add value (with the exception of tax savings from debt that increase the overall cash flow).
3. A company’s performance in the stock market is driven by changes in the stock market’s expectations, not just the company’s actual performance (growth, ROIC, and resulting cash flows). This is the expectations’ treadmill where just because the company has a higher share price, the expectation is that the company has to perform better just to keep up to those expectations.
4. The value of a business depends on who is managing it and what strategy they pursue. Different owners have different abilities to generate different cash flows for a particular business.
If you are in the shoes of a senior executive of a consumer products company, you may want to note the elements that bring your shareholders the greatest value return per $1 revenue invested:
- Introducing new products to the market – $1.75 – 2
- Expanding existing market – $0.30 – 0.70
- Increasing share in growing market – $0.10 – 0.50
- Competing for share in stable market – ($0.25, loss) – 0.40
- Acquiring new business – $0 – 0.20
(Source: McKinsey Corporate Performance Analysis)
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- 5 Steps to Improve your Cash Flow (rushprnews.com)