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Cash flow activities and a firm’s life cycle

 on Thursday, August 4, 2016  

Cash Flow Activities and a Firm’s Life Cycle
A helpful framework for intuitively grasping the information conveyed through the organization of cash flows involves the product life cycle concept from economics and marketing. Individual products (like goods or services) move through four phases: (1) introduction, (2) growth, (3) maturity, and (4) decline. Firms also evolve through these phases, as graphically depicted in Exhibit 3.1, which shows stylized patterns for revenues, net income, and cash flows over the life cycle.
A Firm’s Life Cycle: Revenues
The top graph shows the pattern of revenues throughout the four phases, which typically follows a period of growth, peaking during maturity, and a subsequent decline as customers switch to alternatives. Obviously, the length of these phases and the steepness of the revenue curve vary by type and success of a product. Products subject to rapid technological change, such as semiconductors and computer software, or driven by fads, such as clothing fashions, move through these four phases in just a few years. Other products, such as venerable staple products like Campbell’s soup, Disney movies, Marlboro cigarettes, Gillette razors, Kellogg’s cereal, and Michelin tires can remain in the maturity phase for many years. Although it is difficult to pinpoint the precise location of a product on its life cycle curve, one can generally identify the phase and whether the product is in the early or later portion of a phase. A typical firm provides numerous products or services, so the applicability of the theory and evidence for single products is more difficult when firms are diversified across numerous products at different stages of their life cycle. Nevertheless, these patterns are descriptive of firm performance over time as they introduce new products and discontinue older ones.

Firm’s Life Cycle: Net Income
The middle panel of Exhibit 3.1 shows the trend of net income over the life cycle of a product or firm. Net losses usually occur in the introduction and early growth phases because revenues are less than the cost of designing and launching new products. Then, net income peaks during the maturity phase, followed by a decline

A Firm’s Life Cycle: Cash Flows
The lower panel of Exhibit 3.1 shows the cash flows from operating, investing, and financing activities during the four life cycle phases. As with revenues, the length of phases and steepness of the net income and cash flow curves vary depending on the success and sustainability of a product or a firm’s operations and strategy. For example, PepsiCo’s systematically large positive net income and cash flows from operations are consistent with PepsiCo’s products (in aggregate) being both mature and profitable During the initial introduction of a product or business, revenues are minimal; therefore, net income and net cash flows from operating and investing activities are typically low or negative, and the firm relies heavily on cash flows from financing activities. As the growth phase accelerates, operations become profitable and begin to generate cash. However, firms must use the cash generated to fund activities such as selling products on credit (that is, accounts receivable) and building up inventory in anticipation of higher sales volume in the future. Thus, because these expenditures are accounted for as assets on the balance sheet rather than being expensed immediately, compared to cash flows from operations, net income usually turns positive earlier than do cash flows. The extent of the negative cash flows from investing activities depends on the rate of growth and the degree of capital expenditure needs and asset intensity. Continuing from the introduction phase, firms obtain most of the cash they need during the introduction and growth phase by borrowing or issuing stock to external investors

As products and businesses move through the maturity phase, the cash flow pattern changes dramatically. Operations become profitable and generate substantial positive cash flows because of market acceptance of the product and a leveling off of working capital needs and asset acquisitions. Also, with revenues leveling off, firms invest to maintain rather than increase productive capacity. During the later stages of the maturity phase, net cash flows from sales of unneeded plant assets sometimes result in a net positive cash flow from investing activities. Firms can use the excess cash flow from operations and, to a lesser extent, from the sale of investments to repay debt incurred during the introduction and growth phases, to pay dividends, and to repurchase outstanding common stock. During the decline phase, cash flows from operations and investing activities taper off as customers become satiated or switch to alternative products,  thus decreasing sales. At this point, firms use cash flows to repay outstanding debt from the introduction and growth phases and can pay dividends or repurchase common stock from equity investors.

Few business firms rely on a single product; most have a range of products at different stages of the life cycle. A multiproduct firm such as PepsiCo can use cash generated from products in the maturity phase of their life cycle to finance products in the introduction and growth phases and therefore not need as much external financing. Furthermore, the statement of cash flows discussed in this chapter reports amounts for a firm as a whole and not for each product. If the life cycle concept is to assist in interpreting statements of cash flows, you should appreciate how individual products aggregate at the firm level.

Knowledge of competitive industry dynamics and trends can help guide you through an assessment of firm-level cash flows. For example, investor excitement in technology-driven industries such as biotechnology most often peaks during the growth phase. Although such firms may have some products at various stages of the product life cycle, the interest is in forecasting the emergence of new technologies that translate into new products that might generate large profits and cash flows. A good example is Apple, because their iPads represent growth potential in the face of declining desktop sales. In contrast, many consumer food companies are characterized as being well into the maturity phase of overall product life cycles. Branded consumer food products can remain in their maturity phase for many years with proper product quality control and promotion, such as General Mills’ Cheerios.

Companies continually bring new products to the market that replace similar products that are out of favor, but the life cycle of these products tends to be more like products in the maturity phase than introductory products in the growth phase. Certain industries in well-developed economies like the United States, including textiles, appliance repair, and automotive, are probably in the early decline phase because of foreign competition, price declines, and/or outdated technology. Some companies in these industries have built technologically advanced production facilities to compete more effectively on a worldwide basis and have, therefore, reentered the maturity phase. Other firms have diversified geographically to realize the benefits of shifts to foreign production, which also prolongs their ability to enjoy the maturity phase of their portfolio of products
Cash flow activities and a firm’s life cycle 4.5 5 eco Thursday, August 4, 2016 Cash Flow Activities and a Firm’s Life Cycle A helpful framework for intuitively grasping the information conveyed through the organization...

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