Like the waterfalls that cascade into Yosemite Valley, cash flows are the life source for a business. This becomes especially apparent when a business runs low on cash and is forced to prune people, product lines and expenses just to survive.
The key to having cash flows that optimize the value of a business are predictable, sustainable and growing. Predictable cash flows are valuable because they provide certainty and facilitate planning. Sustainable cash flows are valuable because they are recurring and long-lived. Growing cash flows are valuable because growth is vital to any business in order to gain market share and to offset cost inflation.
Net cash flows consist of both inputs and outputs – costs and revenues. Both need to be managed in order to maximize value. The need for a disciplined approach to costs and expenses has been highlighted these last few years in response to the recession. A similar discipline should apply to an evaluation of a Company’s revenue streams in evaluating which are profitable, predictable and the most likely to be sustainable and to grow. In a typical software company, maintenance renewals may be the predictable and sustainable revenue stream, new licenses may be the growth stream, and professional services may be an adjunct profitable stream. Because of the symbiotic relationship of these streams, management may find that decisions that impact one revenue stream will impact the others. The guts of the business can be complex and messy. The management team that best understands its business and that is proactive rather than passive will be in the best position to create value.
Profitability is related to but not the same as net cash flows. In accounting terms, net cash flows are net income after tax plus noncash charges such as depreciation expense and stock option expense, less incremental working capital needs, less capital expenditure needs. What might cause net income to be high and yet net cash flows to be low or even negative? Often times the culprit is working capital. If receivables grow faster than payables working capital needs are higher and cash flows are lower. This may occur because of rapid growth of a new product, or it may occur because the company is offering liberal payment terms. It might also occur because the company has staffed up its accounting department and bills are being processed faster. The point is that, just as with costs and with revenues, working capital needs to be managed in order to optimize cash flows and the value of a business.
The common denominator with valuable and healthy cash flows is capable management. Just as grapevine pruning is needed to maintain size, shape and productivity, business management is needed to actively manage a business so that it can reach its potential.
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