By Svenkat & Ravikanth Rao
In several owner-managed businesses, the efficient management and allocation of cash flow is pivotal, yet it is often overlooked. Companies spend tremendous time budgeting for revenue and profits; most also invest considerable time in devising strategies to improve cashflow velocity, but not much time is allocated to thinking through how the cash needs to be deployed. For a company to not only survive but thrive in today’s competitive landscape, a conscious approach to how cash is utilized can significantly enhance its enterprise value.
Link Between Cash Flow and Enterprise Value
Enterprise value (EV) is a measure of a company’s total value, often used as a comprehensive alternative to equity market capitalization. Cash flow influences EV through its effect on operational efficiency, investment in growth, and financial health. Allocating cash wisely ensures that resources are available for strategic investments while maintaining healthy liquidity to withstand economic fluctuations.
For instance, at the start of the year, an owner-managed IT services company will need to consider how much cash to allocate to ongoing “Business As Usual” expenses (consider salary increases, rental payments, software license costs etc), discretionary spends (consider opening new offices, branding, travel for new business generation), and one-off strategic initiatives (consider hiring of a key business development leader, acquisition of another firm in the same or adjacent space etc).
The link between cash flow deployment and enterprise valuation is direct. Public markets for instance will ascribe premium valuations to companies for not only generating healthy revenue growth and improving profit margin but also to the effectiveness of Return on Invested Capital (RoIC) i.e. how well is surplus cash deployed to generate further profits.
Common Missteps in Cash Flow Allocation
Companies often err by mismanaging their cash reserves, either by hoarding cash excessively, leading to underinvestment, or by overspending without adequate planning for future needs. Such missteps can constrain a company’s ability to respond to opportunities or challenges, directly impacting its market standing and potential for growth.
Strategies for Optimizing Cash Flow Allocation
Directional Objectives: The starting point for a cashflow allocation plan is what is the directional objective being pursued by the owner-manager over the next few quarters. For instance, in a business with limited growth opportunities, it may be best for the cash to be distributed as dividend, so that the owner-manager can make better use of it in his/ her family office.
If the business is delivering RoCE which is lower than its cost of debt financing, it is best to pay down the debt, particularly given today’s high-interest cost environment. If the above two scenarios are not applicable, the cash is best retained in the business. The owner-manager will now need to decide whether to maintain the cash in the books (for example if he/ she sees headwinds in the business or an impending economic slowdown/ recession) or whether to re-invest and grow the business.
Measuring spend efficiency: The ability to measure the possible outcomes from each item of proposed spending is a fundamental pre-condition to cash flow allocation. For example, the owner-manager will need to know or estimate, the incremental impact on sales from a brand promotion activity, incremental revenue from avoiding production loss by spends on preventive maintenance, incremental sales productivity from investing in a CRM implementation, incremental revenue from opening a new office and investing in the sales team to man it, payback calculations on a new capex, or synergies from making an acquisition.
The fundamental question is “Do you know if your cash is sweating for you and by how much”? If the fundamental building block of measuring spend efficiency is not in place, owner-managers are well advised to appoint a CFO or seek professional assistance.
Unfront Planning: Regular budgeting, coupled with accurate cash flow forecasting, allows companies to anticipate future financial needs and adjust their spending accordingly. Having a conscious, documented, well-articulated plan which clearly calls out what spends will be greenlighted in base case, realistic and best case scenarios are very helpful in avoiding ‘ad-hocism’ in cash flow allocation.
For instance, a $100mn revenue branded derma products company with outsourced manufacturing to CDMOs could say that if we achieve our realistic cash flow surplus in Q2, we will make planned investments in rebates to the distribution channels to push revenue growth. However, if the best case is achieved, we will go beyond the realistic case spending and that the surplus will be set aside as a pool for investments in acquiring new brands to grow revenue inorganically
Regular Monitoring: Implementing performance monitoring tools to track available and planned cash surplus and their allocation provides real-time insights, enabling more informed decision-making on trade-offs monthly review of cash flow generation and allocation, with regular updation of forecasts, will allow for scientific deployment of capital into earmarked initiatives
Practical Real-World Benefits of Effective Cash Flow Deployment
Consider a mid-sized textile company that needed assistance with its cash flow allocation. Collaborative efforts resulted in a return on incremental invested capital above 25 per cent and an overall improvement in RoCE (Return on Capital Employed) by 400bps. Also, clarity was provided to the owner-managers about where they should deploy the cash at the beginning of the year. This boosted the confidence level and conviction of decision-making by the owner-managers.
The other significant benefit was aligning the mindset and expectations of all senior leadership within the company. The framework to make decisions on spends was well articulated and understood. This took away a lot of the previously experienced heartburn, anxieties, and back and forth on decision-making. From a cultural standpoint, this initiative assisted in building a mindset of investing cash in the places where the best possible risk-adjusted RoCE could be achieved in the long term on a sustainable basis.
Conclusion
Conscious cash flow allocation is a critical, though often neglected, lever in boosting a company’s enterprise value. By managing cash flow strategically, owner-managers can ensure they are positioned not only to meet immediate operational demands but also to invest in growth opportunities that enhance their long-term value, particularly when they are considering taking private equity funding or taking their company to an IPO. As such, mastering cash flow allocation should be a priority for any business aiming to increase its market standing and secure a sustainable future. Cash is limited, let’s deploy it wisely and consciously.
Svenkat is the Co-Founder at Practus and Ravikanth Rao, Engagement Partner (USA) at Practus. Views expressed are personal. Reproducing this content without permission is prohibited.