Understanding Cash Flow, the Cost of Capital, and Maintenance

It helps to understand how the finance people manage the funds that are used, in part, to support the maintenance function. This understanding will allow maintenance to align itself with how the company is actually run and it will help anyone writing up a capital request understand what the final approving authority (e.g., the CFO) is really looking at.

It’s typical to think of payback time. Homeowners often do this when considering energy savings upgrades, such as window replacements. It makes sense for people who intend to keep their home until it’s an “empty nest” in fifteen years to know the payback on those new windows is seven years. They might not be as enthusiastic about the purchase if they are planning to relocate in two years, though. But you cannot carry this thinking into corporate finance.

Companies borrow money at X% and invest it to make Y%. That X% is what is known as the “cost of capital”. But, the company also has to determine its ability to make the payments on the capital while also paying its other expenses. Cash flows in and cash flows out. This in and out flow of cash is what we call, wait for it, “cash flow.”

If a business runs out of cash, it can’t meet its expenses, loan obligations, or other financial needs. It does have some options when cash runs out. It can, for example defer payments, default on payments, renegotiate, seek additional financing, or refinance existing loans. If cash flow problems are severe enough, it may lay people off, sell assets, or simply close down an operation that is in a cash flow slump. Sometimes, it’s easy to borrow more, but that hurts the balance sheet and the rates may be unfavorable. The other options tend to be unpleasant at best. So a business must be careful about managing its cash flow.

When considering a capital spending request, the analyst “draws out” the cash flows. This term refers to the old paper-based process that involved a drawing, now computer programs automate the tedious part.

How does cash flow work when you are making a capital request? Say you want to spend $9,000 on a lighting upgrade that will reduce the electric bill by $200 a month. That’s a $9,000 cash outgo at the start, followed by a series of $200 inflows that will get you to break-even at 18 months. That sounds a lot like an 18-month payback, but it’s not the same thing:

When you add in the cost of the financing to pay for the $9,000 upgrade, the monthly cash flow might be negative for the term of the loan.
The cash flows will be drawn out for the expected life of the acquisition. If the new lighting is expected to last 30 years, that’s a lot of $200 inflows past the 18-month loan period.
All negative cash flows will be calculated and added in. These include anticipated maintenance and repairs. The values used might be based historical values, so if you have something different you need to include it and explain it. For example, there’s no relamping cost involved with the new LED lighting.

So, what about that return on the investment? How does the bean counter determine the Y% value? It’s not like a bank CD where you get a specific percentage back. The bean counter does this by using software that calculates the Modified Internal Rate of Return (MIRR) or something similar. MIRR considers those cash flows, which is why they must be drawn out.

Now the MIRR of your proposed project will be considered against the MIRR of other proposed projects and all of it will be considered against the company’s overall cash flows (these are what the company uses to pay for capital and normal expenses). And all of this will be compared to the company’s strategic plan. Sometimes that comparison will come first. For example, your project is for the company’s widget plant. But the company plans to exit the widget business this year. So no matter what MIRR your proposal has, your proposal will be rejected unless it’s necessary to keep the plant making widgets until the date that production is slated to end.

Understanding how the finance people think and what they are trying to do will help you understand what information to provide to them to get what you need. Consider two ways of making an appeal for a thermographic camera:

Thermographic cameras have saved plants thousands of dollars a year by spotting emerging problems.
ACME Products has a production machine similar to our Line 2 and Line 4, each of which generate $55,000 of revenue per hour for 22 hours per day 6 days per week. Their machine failed in the middle of a production run resulting in scrapping $6,000 of work in progress, 3 hours of downtime, and $1,500 in repair costs. Forensic analysis showed the cause would have been fixed proactively if caught by thermography, with $0 scrap, 45 minutes of downtime, and $450 in repair costs. According to industry sources, the risk of such an event occurring in any given year is roughly 7%. Lines 2 and 4 have been in service a combined total of 8 years.

In the first one, the claim is only vaguely quantified and there’s nothing to tie it to anything specific at your plant. In the second one, you have provided specifics from which they can draw out the cash flows. And you’ve included a risk estimate.

You can apply this understanding to much more than capital requests. When you submit maintenance performance reports to higher management, what is in those that justifies raises, training, and hiring? How are you improving cash flows, and how might you improve them going forward? Buying test equipment does not improve cash flow. Using specific features available in Model X testing device to prevent or more quickly solve a specific downtime problem does improve cash flow. Instead of trying to save a little money on a test equipment purchase by getting “base plus” (one step up from the bottom), save your company a ton of money by purchasing exactly what you need to prevent or more quickly solve a specific downtime problem.