In the economic profitability calculations made in the context of the selection of investment projects, the “maximum cash flow” is not in itself a selection criterion but may constitute a rejection criterion when it is too important. In some industries, it is a key element in deciding whether to launch a new project. For companies working “on business”, this criterion is used to negotiate “co-financing” of development costs.
An additional criterion of profitability criteria
Remember that the economic profitability of a project is calculated from the investment cash flows (FTI) and operating cash flows (FTE) specific to this project. The maximum cash pool is based on discounted and cumulative free cash flow (FTD = -FTI + FTE). It is often visualized on the graph of the cash flow curve of the project.
In itself, the maximum cash flow does not evaluate the intrinsic economic performance of the project:
- The internal rate of return (IRR) measures the intrinsic profitability;
- Net Present Value (NP) and Profitability Index (PF) measure the value created above an expected rate of return;
- The payback period estimates the time after which the company will have recovered the down payment corresponding to the initial investment.
A project may be very profitable but difficult to fund because the company does not have sufficient resources (capital contributions or current accounts of partners, reserves, loans to MLT, credit lines to CT …) to finance this maximum trough or not on the whole the business and projects it wishes to undertake.
This cash gap results from:
- Investments in fixed assets;
- Potential start-up losses and the constitution of working capital requirements that are deducted from operating cash flow
Illustration of the cash gap
An aeronautical equipment supplier manages several projects on behalf of its customers. These projects have an extremely long average duration, up to 40 years and require significant initial investments: research and development, prototyping, production lines. The contract provides for the supplier to finance these development costs itself, at least in part, and then recovers this down payment from the sale price of the parts over the period of sale.
Financial resources being limited in nature, before accepting a new business, in addition to the criteria of economic profitability, the equipment manufacturer will ensure that this maximum cash flow, called in the “low point cash” business is finance-able and does not not disproportionate to the value created by the project.
How to act on the maximum cash pool
First, as with any project, the company strives to act on the cash flow of the project to improve its performance:
Invest gradually by ensuring that some of the investments are made when the GTF has become positive;
Outsource investment-intensive and non-strategic BFR activities;
Strive to variabilize loads to gain flexibility and limit losses in case of under-activity;
Use underutilized assets in the enterprise taken into account at low or no marginal cost;
Finally, the supplier will endeavor to obtain from his client, as part of the commercial negotiation, a co-financing of the development cost in order to reduce his own maximum cash-flow and to financially involve his client. If you wanna learn more about such business terms and terminologies, than you need to visit Business Study Notes. Business Study Notes is all about business tips and tricks, entrepreneurship management, business education and exam study as well. We may also say that the student of MBA & BBA may easily get ready for their exams by reading Free Notes Online on Business Study Notes.