This posting is a case study that exhibits the cash flow and financial statements for a small business, where the intention of the owner is to open a second branch as a result of the successful operation of its initial retail and manufacturing location. Is it worth it? There is a potentially strong market indicated in the second potential location but that second location is three thousand miles away across a wide expanse of ocean, and so some careful thought and planning would be prudent and sensible. This analysis will assess if the proposed expansion is likely to be profitable, presenting cash flow and financial statements to discover if an expanded business will generate a larger return on investment, without risking the current single location that is already a good investment.
Cash Flow and Financial Statements
Included in the process are a set of financial statements including income statement, balance sheet and cash flow statements, which can all be used to exhibit the financial health of the company. The objective is the viability of the business over the long term and if it is capable of servicing loans that would finance its expansion. In the course of analyzing the numbers as presented in financial statements, it will become obvious that this company can most certainly service loans enough to finance a new location.
The income statement for a business is similar to a profit and loss statement, presenting a picture of the financial performance of a company over a period of time. In the case of Figure 1, The Company has shown a marked increase in net income (net profit) of 15% between 2013 and 2014. 15% of growth from one year to the next is a very good return on investment and shows a potentially healthy and well run organization.
Figure 1. 2013 and 2014 income statements
In Figure 1, corporate taxes are calculated at a marginal rate of 35% for the sake of simplicity. Given that company profit is in the range of the lowest corporate tax rate, it might be appropriate to display a calculation of actual (average) taxes as shown in Figure 2. However, using the average tax calculation would show bigger profits, but also a decreased net income change between 2013 and 2014 of only 12% as opposed to 15%. It is unknown if GAAP rules allow use of the better number but this situation is a good example of gently manipulating numbers in an ethical manner, in order to paint a slightly better picture, especially given that more loans are being pursued.
Figure 2. Average tax rates calculation
The balance sheet presents a brief picture of the difference between what a company owns versus what a company owes, where the difference between the two is the equity of the company. The equity or shareholders equity is effectively a long term liability and is the amount of cash that is owed to shareholders, owners and investors. Also, investors do not include organizations such as banks who have loaned capital to a company because a bank makes income on making loans and charging interest as part of the repayment terms. The balance sheet as shown in Figure 3 for The Company shows marked increases across the board in all categories. In more detail, there is a clear increase in liquidity or fluid capital (current assets), which clearly indicates very healthy expansion and a better capacity to re-invest in the next year, and most importantly a much better capability to take on a larger debt load.
Figure 3. 2013 and 2014 balance sheets
Cash Flow Statements
Cash flow can show how money flows through a company. One of the fundamental things that people who do understand business is that cash flows from one point to another. For example, a company might make short term loans to cover labor costs until accounts receivable are cleared and in the bank, without which the company might not be in business, or at least unable to handle orders of a useful size. Being in business is in many ways a lot about cash flow in that one makes certain that one has the funds available to pay critical bills, in a reasonable time frame and in full, without which there is no business.
Operating Cash Flow
The operating cash flow is the tangible liquid or ready cash that is generated as a result of normal day to day activities in manufacturing, buying and selling things (the incomes and expenses). Figure 4 shows operating cash flow where the number has increased between 2013 and 2014, and showing very clearing that business is healthy because flows are positive and expanding because there is more money going through the company in 2014.
Figure 4. 2013 and 2014 operating cash flow
Cash Flow from Assets
The cash flow from assets is known as the cash flow identity of a business, meaning that a company owns assets, both liquid and static, and those assets allow for the generation of revenue. For example, specialized bicycles cannot be sold without a place to sell them such as a bicycle shop, and thus it makes sense to open another bicycle shop in a different location in order to sell more bicycles. And so each separate location will be contributing to the cash flow from assets, and hopefully selling at least twice as many items. Cash flow from assets is calculated using operating cash flow (see Figure 4), net capital spending (see Figure 5), and the change in net working capital (see Figure 6).
Figure 5. Net capital spending calculation for 2014
Figure 6. Net working capital calculation for 2014
The final resulting cash flow from assets calculation is shown in Figure 7.
Figure 7. 2014 cash flow from assets
Cash Flow to Creditors and Stockholders
Cash flow to creditors is a measure of how much debt there is and how much it is costing the company, and in some respects how well loans are being put to work in the generation of revenue. This is shown by a partial calculation of net new borrowing in Figure 8 and a final result for cash flow to creditors, as shown in Figure 9.
Figure 8. Net new borrowing calculation for 2014
Figure 9. 2014 cash flow to creditors
The calculation in Figure 9 shows that the company increased its debt load a little but still paid less in interest, and thus more money flowed into the company than it did to creditors; this situation is typical of a company starting out.
Cash flow to stockholders is similar to cash flow to creditors in that it is a measure of how much money is going back into stockholders pockets as a result of the equity invested into a company, by those same stockholders. Again, Figure 10 shows an initial calculation for net new equity and in Figure 11 a final calculation of cash flow to stockholders.
Figure 10. Net new equity raised calculation for 2014
Figure 11. 2014 cash flow to stockholders
Figure 11 shows that because no dividends were paid out to stockholders that no profits were disbursed, or any equity paid back to stockholders. And thus the equity or value of the company increased and also that value is to be plowed back into the business to help it to continue to expand.
Current Company Health
The health of The Company is obviously very good health. Sometimes a company is valued for sale based on what is called a profit multiplier and a simple compound interest calculation could be used (similar to amortization for a loan), if the person doing the selling is persuasive. The compound interest calculation would be an extrapolation of potential profit and gain over a number of years into the future. In the case of The Company there is only one year that can be used to make a guess at profitability, out to say five or ten years into the future. Here are some simple numbers:
Net income for 2013 = $34,527
Net income for 2014 = $39,529
Change in income = $5,002
Percentage change in income = 15% (14.5% to be precise)
And a simple formula for calculating compound interest is fv = pv (1 + i ) n, where interest = 15%, present value = $39,529, and n = 5 or 10 years:
future-value = $39,529 * ( 1 + 0.15 ) n
= $79,506 at 5 years or
= $159,916 at 10 years into the future
The above formula is about the same as doubling profits every five years, a slightly better return than stock market investments that are reported to double every seven years. Also, bear in mind that if this company does place another store in a new location, it might experience a heavy growth period in the year the new location is opened. However, additionally note that 2013 to 2014 was probably a heavy growth period as a result of the original location opening. So it is certainly possible that a 15% growth rate could be maintained or even exceeded in 2014 with the opening of a new location, but also implying that if further new stores are not opened in subsequent years, and in good locations, that perhaps the growth rate will be much lower after 2014, even if still showing healthy profit.
In reality profit multipliers are much simpler than using a compound interest formula as described at (Houston Chronicle). Profit multipliers can also be very much healthier than doubling every five years, and perhaps doubling as much as every single year for some industries. In this second situation the number of years of profit multiplying that a business can be sold for, may determine the market value of a company.
The cash flow and financial statements matter because they exhibit a sound and properly running business, which shows that an expansion of the business is a sensible path to take. However, there are obvious dangers in expanding the asset base of a business simply because of the increased cost in servicing those assets. This business in particular is interesting because it does make plenty of sense to open a second location with plenty of potential new clients in that location. One risk for this company and a second location is the remote location and the owner cannot be in two places at once; trusted staff would have to be hired and trained.
At a minimum there has to be at least a small allowance for a reasonable amount of marketing for the new location in addition to travel expenses, which in the first year could be quite high. It is also possible that the company owner might want to consider a temporary relocation.