Building Enterprise Value: Revenue is vanity and profit is sanity, but cash flow is reality
Companies looking to grow their value should focus on the fundamentals of cash flow. Cash is the oxygen that makes companies run. This paper reviews ways to enhance enterprise value, including explaining the drivers of company valuations, sharing ideas on how to boost value, and suggesting ways that cash flow forecasts can drive key decisions. Business can appear complex, but cash is a simple thread that can help you stay focused on what matters.
Cash is the liquidity that makes our economy run. From the largest enterprise to the smallest proprietorship, cash is needed for commerce and is an essential yardstick of any business’s health.
The saying goes: Revenue is vanity and profit is sanity, but cash flow is reality.
Smart companies follow cash closely, for cash can be hidden across an enterprise. For example, when Kraft was looking for ways to fund new growth, one lever was to reduce inventory levels. Through a series of tactics, Kraft freed up $700 million of cash, which paid for a lot of initiatives.1
This paper offers a perspective on making businesses more successful and more valuable. Cash will be a frequent theme throughout. We will:
- explain what drives company valuations,
- share ideas on how to boost valuations, and
- suggest ways to build a cash flow forecast.
Before we begin, we will first turn to a primer on measuring income and cash.
Accounting is where cash and value are measured. There are many great resources available for those new to accounting. A particularly good book is the HBR Guide to Finance Basics for Managers.
The three major financial statements provide ways to measure a company’s performance.
- Balance Sheet. This shows a snapshot of a company at a point in time. This picture includes the company’s assets (e.g., cash, inventory, property), liabilities (e.g., payments due to others, debt), and shareholder’s equity (what would be left to disperse to the shareholders if the company was liquidated at fair values).
- Income Statement. This shows the revenues, expenses, and bottom-line profits over a specific time period. The income statement includes different “bottom lines.” One is net income, which is profit after all charges and taxes. Others are operating earnings (often called EBIT – earnings before interest and taxes), which measures profits before financing dynamics and taxes, and EBITDA, which takes EBIT and adds back non-cash charges around depreciation and amortization. EBITDA is often used as a proxy for the cash a business generates from regular operations.
- Cash Flow Statement. This shows how much cash is available and how and why it changes over time. Specifically, this statement traces how changes in the balance sheet and income statement affect cash. The Cash Flow Statement starts with the cash on hand at the last snapshot (as shown in the Balance Sheet). Then the cash provided from Operating Activities is added, including the net income earned after adjusting for non-cash charges (like depreciation) as well as other sources and uses of cash from general operations (like changes to inventory or accounts receivable). From this, cash from Investing Activities (like an outflow due to investments in a new factory) and Financing Activities (like an inflow from raising new debt) are incorporated. The result is a new snapshot of the cash on hand along with an understanding of the factors that produced it.
An accurate measurement of cash is the foundation upon which value can be built. But a business’s value depends on more than just the cash or other liquid assets present. As we will explore in the next section, the value of an enterprise depends on how all the financial results (as shown on the three financial statements) intersect with strategy.
Drivers of Company Valuations
A company’s value is a function of what someone is willing to pay for it. As an investor, you consider valuations all the time. If you buy a share of stock in a public company, you want the share price to represent a fair value and offer a fair return. If you invest in a private company – whether as an entrepreneur, through a private equity firm, or in some other manner – you also want to pay a price commensurate with the risk and return profile of the enterprise.
Valuation is complex and is derived from a combination of objective and subjective variables. A company will have a higher valuation with:
- Higher profits. Investors want a profitable company. For every dollar of revenue, they want as much bottom line as possible.
- Higher cash flow. Investors want a lot of the profits to be available after key investments are made. Some companies require a lot of cash to keep them running. If you’re Toyota, for instance, you have capital equipment that needs to be maintained in your factories. Investors like businesses that demonstrate strong cash flow even after these kinds of necessary investments.
- Robust cash flow. Investors don’t like risk and uncertainty. They don’t want cash flows that fluctuate wildly or are subject to the whims of one large customer or supplier. Having a diversified foundation of cash flows, built on a sound strategy that limits short- and long-term risks, means the business is robust.
- History of performance. Strong track records breed confidence, so investors will place more value on a company that has grown its top and bottom lines reliably. Investors also assign value to strong operating metrics in areas such as product quality, delivery accuracy, and customer thrill. Measurements like these demonstrate operational excellence and support superior valuations.
- Plan for future growth. Past profitability is great, but investors want even more profits and cash tomorrow. This requires a credible strategy that’s based on a clear understanding of the market, a sound business model, and specific initiatives that are expected to boost value.
- Fewer assets. A business will be valued more if it requires fewer assets to yield current or future profits. Annual capital expenditure is a cash flow tied to the overall asset intensity of a business. The more efficiently a business runs, the fewer assets are required and the less cash is needed. This allows for a higher return on investment.
All of the above are quantitative considerations that guide company valuations. But ultimately, it is people who get things done. All else being equal, a company with a stronger team will garner a stronger valuation. Our white paper, People Power: Building a Profitable Business Through Human-Resource Excellence, discusses ways to strengthen a team.n will have its own set of journeys, touchpoints, and interactions. Furthermore, these can be different for different customer segments. Fully dissecting the customer experience – by truly walking in the customer’s shoes – creates the platform for thinking through smart enhancements.
Improving Cash Flow and Valuations
Cash flows, and therefore valuations, are the result of many decisions. Some are longer-term (strategic) and others are shorter-term (tactical).
Strategy is about making tradeoffs to deliver the best return on scarce resources. A thoughtful strategy helps build real value in an enterprise. Our white paper, Designing a Strategy for Growth: Blueprinting in Six Steps, offers a practical approach to crafting a strategy. In a nutshell:
- Decide what business you are really in. This is essential as it frames the competitive landscape and the skills you need to succeed.
- Assess your current situation. You must diagnose your strengths and weaknesses as well as where the market opportunity lies.
- Set your vision and targets. This represents what you’re trying to accomplish with your scarce resources.
- Prioritize actions. This step represents the “how” to achieve your vision. This should encompass ways to leverage your strengths and bolster your weaknesses in order to grow effectively.
With the strategic plan in mind, another macro consideration is how to finance the business and put the plan in action. There are two primary sources of funding – debt (capital borrowed from banks or underwritten through bonds) and equity (capital injected by individuals). Most businesses have a combination of these two sources, with the ratio between debt and equity referred to as leverage. The ultimate blend of funding is governed by several dynamics:
- Debt is usually cheaper than equity. This means that the returns expected by debt holders are below the returns equity holders want; this is due in part to the fact that debt holders have a preferred claim on the company’s assets, which reduces their risk.
- More debt allows for greater equity return on investment. For example, consider $1 million of assets funded with $800,000 in debt and $200,000 in equity. If these assets appreciate in value by 20% to $1.2 million, the return to the equity holders is 100%. (Paying back the $800,000 in debt from the $1.2 million leaves $400,000 in equity value, which is a doubling of the original $200,000 investment.) This is the power of leverage.
- But too much debt increases the risk for all investors. Debt holders and equity holders alike worry if there is not enough cash flow to service the debt (interest and principal payments) and also fund future expansion or generate returns on top.
These issues of strategy and financing set the foundation for more tactical decisions to drive cash growth.
Many actions can improve cash flow.
Some initiatives target the income statement. More net income from revenue growth and/or expense controls can yield more cash. The exact impact depends on the profit margin of the new revenue dollars and any impact on margin for the incumbent business. The wide array of levers includes:
- More volume from new products, expanded distribution, increased trial, greater usage.
- Higher price realization from list-price and trade-spend management, new products.
- Lower cost-of-sales from smarter procurement, design and specification changes, production efficiencies.
- Reduced expenses from removing unnecessary costs, improved efficiencies, tighter controls.
Cash is also accessed by looking carefully at the balance sheet. Initiatives include:
- Cutting inventory levels. Inventory often traps a significant amount of cash (see Spotlight below). Inventory turns (the ratio of cost-of-goods to inventory balance) is a good metric of inventory efficiency.
- Collecting receivables sooner. Days Sales Outstanding (DSO) shows how fast you are collecting what your customers owe; the faster you can make customers pay you, the sooner you have their cash.
- Extending payables. The longer you can delay payment to your suppliers (as measured by Days Payables Outstanding or DPO), the more cash you have today.
Small changes in inventory turns, DSO, and DPO can often free up significant cash.
Spotlight on Inventory Management
Inventory can consume a significant amount of cash for two reasons.
First, related to assets on the balance sheet, inventory can represent 20% to 30% of a company’s total assets, depending on the industry sector. To reduce your exposure, ask: Who else in the supply chain is holding inventory, and who can hold inventory instead of me? What could just-in-time delivery do for me?
Second, whatever amount of inventory you are holding leads to expenses on the income statement. Most companies underestimate the true cost of holding inventory. It’s not just the cost of capital of the inventory asset (the cost of the money you have tied up in inventory). Inventory also leads to many other costs, including:
- Pilferage, shrinkage, obsolescence
- Storage and warehousing expenses
- Utilities, maintenance, and taxes on the building
- Employees and machines to handle the inventory
- Costs to track and manage inventory
With proper accounting, companies can find that the annual cost of holding inventory represents 25-30% of the inventory’s book value.
Smart inventory management can dramatically boost your cash flow by reducing both the assets held and the expenses tied to those assets. For example, a company with $1 million of inventory turning 4 times per year could free up $500,000 in cash and save $150,000 in annual expenses if they double inventory turns. This is do-able with the right supply-chain design. Learn more about measuring and reducing the cost of inventory in our white paper, Reducing Total Inventory Cost: A Roadmap to Higher ROI.
Cash management isn’t a task for only the accounting team. Indeed, cash is the oxygen of any business. A business can be profitable but still go bankrupt because there is not enough cash to operate.
So a smart exercise is to forecast cash over time. Creating a detailed financial model is useful, but there is also benefit from a higher-level discussion and issue review. Regardless of the specificity, an operating cash flow forecast should contemplate:
- Sources of cash. Forecasting the cash that will come from business operations (operating profits) as well as expected improvements to how the balance sheet will change.
- Uses of cash. Forecasting key investments that require cash (related to strategic initiatives or daily realities) including expected needs for new assets.
Forecasts should consider multiple scenarios, such as optimistic and pessimistic projections or a scenario tied to a significant strategic shift.
To the extent that the sources of cash are insufficient to cover the uses of cash, then one of two things must happen – either the underlying operating or investment assumptions must be tested to put the sources and uses in balance, or incremental financing must be raised.
In addition to determining financing needs, the best cash flow forecasts tee up questions around a business’s strategy and operating conditions:
- Do we know where we really make our profits?
- Are we investing our cash in the right things?
- Are we utilizing our assets efficiently?
- Are we rewarding employees based on how effectively they manage and grow cash and income?
- How do our ratios (e.g., return on assets, return on sales, inventory turns, DSO, DPO, debt to equity) compare to our competition?2
These questions foster discussion on critical business issues and assist with performance improvement. Companies that outperform with cash growth and cash management will outperform in valuations.
Spotlight on Berlin Packaging
Berlin Packaging is a leading supplier of containers, closures, and dispensing systems. In 2014, the company was sold to a private equity sponsor for $1.43 billion. This price represented a record valuation in the packaging space as measured as a multiple of EBITDA (a proxy for cash flow).
Berlin Packaging was able to achieve this leading multiple because it was able to demonstrate a business history and strategy focused on cash creation. The Berlin valuation was helped by:
- A business model that helps customers and suppliers grow their cash flows through top-line growth, cost savings, and inventory reductions. Every year, Berlin Packaging quantifies the added cash and income customers earn as a unique consequence of working with Berlin. Over the last three years, the company created over $200 million in value for its customers.
- A history of growing organically through a diversified set of customers and tactics.
- A future growth strategy that includes multiple, credible avenues in a large addressable market.
- Efficient cash management and financial structuring that bred confidence among investors.
- Leadership and a highly motivated team with the acumen to execute key initiatives.
While every company has a unique situation, the elements that drive value creation – as Berlin Packaging illustrates – are similar.
Businesspeople want to create a healthy enterprise; they want to grow. Building a valuable company is the result of many decisions – some big and some small. But cash is a thread that weaves through the whole discussion. Cash is the oxygen that makes companies run. This paper shared ideas on how to measure cash, how cash and other variables impact a company’s value, and how to improve that valuation with effective strategic and tactical actions. This thinking, along with the suggestions on how to forecast cash flows, provides a roadmap to grow enterprise value. With regular reflection by looking internally and benchmarking externally, fluency in the language of cash gives leaders and individual contributors alike the tools to find the best ways to tighten the supply chain and create more corporate and personal wealth.
1See At Kraft, Cash is King, CSCMP Supply Chain Quarterly, 2010.
2For a source of financial benchmarks by industry, see Annual Statement Studies: Financial Ratio Benchmarks, published by The Risk Management Association.