Wednesday, October 17, 2012

Which business will grow faster?

I'll give you case of two businesses. I'll first explain the situation around these businesses. 

Business 1: The revenue is growing at 25% annually. Similar is the growth of Profit After Tax. At present, the company has no debt. Return on Capital Employed (RoCE) is at 30%. Operating Cash Flows are 25% of the Operating Profits.

Business 2: The revenue is growing at 25% annually. Similar is the growth of Profit After Tax. At present, the company has no debt. Return on Capital Employed (RoCE) is at 30%. Operating Cash Flows are 120% of the Operating Profits. 

The difference between the above two instances is Operating Cash Flows. What is going to be the impact of Operating Cash Flows?

Business 1: Despite everything good about calculations, the profits made by the business is only on paper. The business has dismal Operating Cash Flows. It suggests that most of the revenues of the company are stuck with the customers of the company. And, in the meantime, the company has to pay its suppliers. So, despite making profits, the company is actually losing cash. Now, two situations can emerge here. First, the company has to take Working Capital Loans to pay off its suppliers. That has interest cost and that'll eat into Net Profit margins and will take away a slice of Operating Cash Flows too when it comes. Second, The business intends to expand later on, but the business is already struggling with Operating Cash Flows and has Working Capital Loans. So, now the business will have to take long-term loans to aid its expansion. Thus, here the business is stuck into loans and interest costs, which'll hamper its real growth down the line.

Business 2: Here, the situation is different. Operating Cash Flows is even greater than Operating Profits. It means that not only the revenues from its customers is coming in upfront, but they're also delaying their payments to their suppliers or they get credit period from their suppliers. Here, the company is flush with cash coming from their business. They have no need for loans for their Working Capital needs. They'll have ample funds to fuel their expansion or growth. Their margins are never going to suffer.

So, who's going to grow faster? Kindly comment below.

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