Capital Allocation Part II: Cash Sources and Uses

Sources & uses of cash

This is Part 2 of a series on capital allocation. A quick recap from last week: We defined the 3 uses of profits as capital allocation. They are:

1. Buy more assets (with the intention of growing sales)
2. Pay off debt and other liabilities
3. Pay dividends to owners

Where we left off was how to assess capital allocation... let's cover one of the best methods for evaluating capital allocation, a tool we refer to as cash sources & uses.

First, why should you care about this?

If you’re looking to understand where your business’s money is coming from and where it’s going, this tool will give you a clear picture. It’s incredibly helpful for improving capital allocation decisions. Remember: allocating capital is what leads to growth and business value!

What is it?

This sounds complicated but it's really very simple. We're taking the cash inflows and outflows of our business and grouping them into various buckets for analysis.

Note that virtually every area of your business can act as both a source and use of cash — here are some common ones:

• Debt — a source of cash when borrowing while debt repaid is a use of cash
• Equity — new investors or equity investments are a source of cash while dividends or buybacks are a use of cash
• Working capital — combination of A/R, inventory, and A/P; typically a use of cash for growing companies, but it can act as a source of cash
• Operating activities — cash generated from your core business operations (i.e. sales and profits)
• Capital expenditures — buying long-term assets (trucks, equipment, buildings, etc.) are uses of cash while asset sales are sources of cash

How do we use this?

Here are the steps:

1. Pull your cash flow statements from your accounting software
2. Group those cash flows into a few buckets (operating cash flows, working capital, asset purchases, debt, etc.)
3. Tally up those cash flows for your desired timeframe
4. Analyze where the cash is coming from / going to

It sounds so simple that you're probably wondering how it could be useful. So let's look at an example.

Below is a table highlighting the cash sources & uses for Nike Inc (NKE) over the past 9 years:

We can see steady cash flows growing inline with revenue. Capex is declining while revenue is growing (potential indicator for underinvestment). Borrowings spiked in 2020 and haven't been fully repaid since. And the majority of cash is going to equity owners through buybacks and dividends (another potential indicator of underinvestment).

The cumulative column is where I get excited...

Over this 9-year period, Nike generated $48.5bn in cash flow from operations and borrowed $7.7bn in debt... with that $56.2bn cash sources, they spent $11.5bn on assets (working capital + capex), $39.4bn was distributed to equity owners, and an extra $5.3bn was stockpiled as cash on the balance sheet.

Some things I like to watch for:

• Is debt consuming most/all of cash flow? Might indicate an unhealthy balance sheet
• Are asset uses (working capital and capex) outpacing revenue growth? Might indicate inefficiency or lower returns on investments
• Is too much cash going to owners? Might indicate too little reinvestment, lower growth, etc.

Key takeaway — Understanding your sources & uses of cash is the best starting point in evaluating capital allocation. It gives us a quick rundown on where money is coming/going. From there, we can determine the return we're getting on those investments (next week's topic!).

Bonus — if you really want to geek out on some additional reading or applying this to public companies, check out this article.