target="_blank" rel="nofollow" href="#i000004820001.png" alt="34662.png"/>
where
[1-32]CE = TSHE + STD + LTD
Substituting values from Tables CS 1-1 and CS 1-2 the ROCE's for Prior and Current Years were obtained:
ROCEPriorYear = 14.2%
or
ROCECurrentYear = 15.2%
Ms. Engel noted that the ROCE was moving in the right direction, but she wasn't sure how these returns compared to other companies in the industry. Given the company's profitability she intuitively expected them to be higher. Also she noted that since the company was beginning to accumulate cash it could drastically increase the ROCE by paying a dividend to decrease the Total Shareholders' Equity, and concluded that maybe she should begin to purchase shares in the company as and when she had excess cash.
To deal with the question of Required Revenue she once again consulted her notes to refresh her memory. The result was the Required Revenue equation, Equation [1-65].
[1-65]
Since she planned to use the material she was preparing in a training program for her staff, she decided to only deal with the Current Year and prepared Table CS 1-5 because she felt it would simplify the process associated with applying the Required Revenue equation.
Table CS 1-5 Required Revenue $'s and %
She then proceeded to use this data and calculated each of the terms.
Ms. Engel then substituted the calculated values for each of the terms in Equation [1-65], which gave her a Required Revenue for the Current Year of $1,260,561,000, which didn't agree with the Revenue shown for the Current Year in the Income Statement ($1,255,643,000).
RRCurrentYear = 676,589,000 + 217,195,000 + 2,459,000 + 364,318,000
= $1,260,558,000
She quickly realized her mistake. The Interest Income of $455,000 actually reduced the Revenue required to cover the Net Income, Depreciation, and Taxes Paid. The correct answer was then obtained by changing the sign on the NetInt term in the Required Revenue expression.
RRCurrentYear = 676,589,000 + 217,195,000 − 2,459,000 + 364,318,000
= $1,255,643,000
While staring at the result of applying the Required Revenue equation she was struck by the fact that in order to create $125 million of Net Income, the company had to generate $364 million of Revenue to pay the taxes and $217 million of Revenue to cover Depreciation and Amortization, and only after $581 million of Revenue had been produced did the next dollar of Revenue contribute to profit.
CHAPTER TWO
The Envelope Equations 28
• In addition to new plant and equipment and software, companies routinely invest in quality control programs, productivity programs, research and development, marketing, sales, and administration. Companies also spend money on consultants, lawyers, accountants, investment bankers, and acquisitions. Expenditures of this type are also investments because the reason for such expenditures is to add or preserve value. If not, why would the company spend the money?
• One could argue that any expenditure that isn't an investment is a waste of money. “Operating Expenses” are really poorly named as such and perhaps “Operating Investments” would be more appropriate.
• Accounting for changes in Working Capital during the formulation stages of building a business plan is often not worth the effort. However, the importance of properly accounting for Working Capital requirements in the later versions of the business plan and managing Working Capital should not be minimized. There are many examples of companies that have gone out of business because they didn't manage their Working Capital (uncollectable receivables and poor inventory management) and ultimately ran out of cash.
• To a significant extent, this book is about Cash Flow since cash is the basic resource required by a business. In the long run, Net Income is the only source of cash and so its importance cannot be overemphasized.
• The amount of debt a company takes on is a function of its capital structure and this is ultimately decided by the owners of the business (shareholders) via the board of directors. In practice, however, the CEO and his management team are responsible for everything that happens in a business. Therefore, the management team can't get a free pass and hide behind the board of directors when it comes to capital structure. Stated simply, they have to deal with the hand that has been dealt and improve it over time.
• One could argue that management should not be primarily judged by how well they manage excess cash, nor should they be penalized for having to cope with excessive debt. A company takes on debt to leverage the return to equity holders and this debt has to be serviced. However, other than the case of a highly leveraged company created in a leveraged buyout29 or a string of poor management decisions, management are not hired to service debt per se. They are hired and should be incentivized to create value, not through financial engineering but through growth. As far as management is concerned, capital structure is only important periodically for such things as financing a major acquisition, and so on. In other words, it's extremely important for operating management, as the stewards of the shareholders' assets, to focus on value creation.
⧉ Introduction
In Chapter 1 the basic relationships between the Income, Balance Sheet, and Cash Flow statements were explored. The concepts and equations that were developed are basic to understanding what drives Cash Flow and Value. However, there are other ways of looking at what drives Cash Flow in a company and one of these involves a set of equations called the Envelope Equations. These equations enable the user to make quick estimates of Net Income and Cash Flow, in a sense on the “back of an envelope,” hence the name.
In this chapter, the study of the Envelope Equations begins by defining and discussing Net Investments (NetInvest) and the Investment Rate (IR). These concepts are then incorporated into the equation developed in Chapter 1 for CFaIA. This is followed by the development of a more general form of the Cash Flow equation incorporating the concept of Net Income Return on Capital Employed (NiROCE). Then, based on the observation that the IR and NiROCE vary little from year to year for many companies, the equations are simplified and then abridged further by focusing on Operational Cash Flows. Next, equations for the Cash Flow and Net Income growth rates, CFaIAg and NIg, respectively, are discussed. Finally, the growth equations are simplified by assuming constant IR's and NiROCE's, and included in the family of Envelope Equations, which are then used in a series of examples and a case study that illustrate how they can be used.
⧉ ROCE and NiROCE
In Chapter 1, the Return on Capital Employed (ROCE) was defined as:
[1-29]
Since the objective of the Envelope Equations is to make quick estimates of Net Income and Cash Flow, the classical definition of ROCE needs to be modified because it deals with EBIT, and to get to Net Income involves introducing additional complexity that isn't warranted given the objective of making quick estimates of NI and CFaIA. To get around this, the definition of ROCE in this chapter is modified to use Net Income in place of NOPAT (Net Operating Profit after