Friday, January 06, 2012

From Energy to Cash Flow

What would be at the top of a business leader’s wish list for the new year? Would it be greater sales volume, easier credit, lower taxes, streamlined regulations, or all of these? These wishes are really different means to the same end: improved capital recovery. In simple terms, capital recovery is the “velocity” at which an investment creates new wealth. From a shareholder perspective, it is the rate of return on capital that’s invested in a business enterprise.

A manufacturing enterprise, regardless of its size or industry, is really just a money-making machine. Think of this machine as all the capital invested in a facility and its equipment. By pumping one full dollar of inputs into one end of a profitable manufacturing facility, revenue value in excess of one full dollar comes out the other end. The greater the surplus value created, the better the business performance. Bottom-line results—the rate and magnitude of new wealth created—reflect choices made by top leaders when managing capital on the behalf of shareholders. You would think that business leaders, especially during an economic downturn, would embrace every opportunity to improve capital recovery rates for their organizations. This is not always so. The following will explain why, and will also suggest a rewarding alternative approach to business investment.

When a business is managed as an investment, the focus is on capital recovery. As the true engine of business, capital never rests; there is no “neutral” position. Whether in the form of cash, securities, or physical assets, capital is at work 24 hours per day, every day of the year, regardless of economic conditions. Capital returns are both positive and negative. Revenues are positive results, while interest costs and tax liabilities impose a cash outflow, like revenues in “reverse.” For obvious reasons, most business leaders seek limits on the taxes and regulations that diminish the investment performance of their enterprises. Substantial resources are devoted to lobbying against taxes and regulations. Yet while this ongoing political battle rages, some opportunities for improved capital recovery are routinely ignored. One opportunity is derived from the cash flow that a business commits to energy consumption. Furthermore, business leaders can find these opportunities literally under the roof of their own facilities, wholly within their direct control.

Energy is an ingredient of every manufactured product. While the sources and kinds of energy used may be optional, its consumption remains inescapable. By simply opening its doors in the morning, a manufacturer commits a cash flow to powering up its facility. While some observers dismiss energy as an insignificant “cost of doing business,” this conclusion ignores other important business impacts. Industrial equipment may operate for years, if not decades. Seemingly mundane equipment selections made today for boilers, furnaces, air compressors, motor drives and the like will impact operating costs—and therefore cash flows—for years to come. Many business leaders are surprised to learn that energy consumption can represent over 90 percent of the total life-time cost of ownership for these assets.

Why do the business impacts of energy use go largely unnoticed? The answer, generally speaking, reflects divided accountabilities among managers within the manufacturing organization. For example, the chief engineer may recommend the hardware, while the procurement lead administers the contracting specs and bidding process. The finance director signs off on capitalization and finance. A maintenance team handles installation. Meanwhile, the monthly utility bill for fuel and power consumption ends up in the hands of clerks who have no reason to question or even understand the facility’s energy consumption. If more energy efficient technologies emerge, who is motivated to measure their potential cash flow impacts on the business?

If not focused on investment performance, managers are simply guided by departmental costs and budgets. Almost no one, aside from shareholders, is focused on capital recovery. This becomes especially evident in the use of energy and the selection of energy-related equipment. The purchase cost of equipment looms large on budgets, and budgets point to individual accountability. Meanwhile, the constant drain of avoidable energy use is attributable to all staff and departments—while accountability accrues to no one in particular. In the same way, capital expenditures are not evaluated as investments. Rather, they are perceived as “projects” with a simple payback. Note that payback is a measure of time. It tells us that a project will pay for itself in some number of years. Simple payback is the natural (if flawed) investment metric for staff who are devoted to cost and budget impacts as opposed to true business performance. Because it is a measure of time, simple payback fits logically with the calendar-driven world of budget accountabilities. Payback reveals nothing about positive or negative cash flows or their impact on capital performance.

When using simple payback, managers reduce capital investment choices to a yes/no decision. In other words, if a proposal fails to meet a payback target, the proposal is dismissed, allowing managers to just “do nothing.” Unfortunately, the “do nothing” scenario has its own cash flow implications. By failing to reduce avoidable energy consumption, the company commits to a negative cash flow. From an investment perspective, this is capital recovery in reverse. This poses a two-part question: (1) what is the rate of capital recovery offered by the proposed investment, and (2) what is the negative rate of capital recovery that results from doing nothing?

For example, suppose a manufacturer is considering a proposed equipment upgrade would reduce energy waste and therefore improve the company’s overall capital recovery performance. Assume that the company currently generates a 10% rate of capital recovery from its existing assets. Also, assume that any capital not invested in the company is held in mutual funds that earn 3% per annum. The proposed asset has a 10-year economic life. The investment is $1 million, and it yields annual energy savings of $250,000. If the company will accept only those proposals with a two-year payback or less, this project would be rejected. Using pre-tax cash flows and no financing, the following describes the hidden value proposition:

• Accepting the proposal means earning a 21% rate of return on its investment through ten years. The energy savings generated by the proposal through ten years will return the original $1 million investment plus an additional $536,000 in wealth that would otherwise have accrued to energy waste.
• By refusing this proposal, the company will miss the opportunity to earn a 21% rate of return on its investment through 10 years. Worse, the avoidable energy expense represents a negative 21% rate of return on the $1 million that the company failed to invest. The negative cash flow will, within ten years, deplete the “saved” $1 million plus an additional $536,000. In other words, “doing nothing” makes shareholders worse off.
• Refusing the proposal means accepting the continued negative cash flow of energy waste. The company practices capital recovery in reverse, as the wasted cash flow diminishes retained earnings.
• As a consolation, the company will earn a return on its $1 million invested in mutual funds. In 2011, the overall return on stocks was 3%. In the long term, stocks are expected to generate a higher return—more like 8%. But even then, this does not compensate for the 21% negative rate of return.

The cost of doing nothing is quantifiable both as a net present value and as a rate of return—both of which are negative when energy savings are refused. Many companies refuse energy improvements like the example described here because they rely on simple payback measures that obscure true investment results. More importantly, these investment results compromise shareholder returns. Examples like this abound throughout industry. The rewards for converting energy waste to cash flow are especially lucrative for boilers, chillers, air compressors, pumps, lighting, and any other equipment that runs day in and day out.

Energy-saving improvements directly support the goal of improved capital recovery. Tax rebates and utility incentives make these investments even more compelling. These cash flows are available as long as energy is being used. As an investment, energy waste reduction offers impressive rates of return. While these rewards should be compelling in a weak economy, they will continue to boost operating margins during a recovery. Pursuing these initiatives may be among the best choices for the new year.



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