Question

How can an enterprise be rapidly growing, highly profitable and out of money all at the same time......and why is this scenario fairly common?

Answer 1

The three conditions mentioned in the problem, namely rapid growth, high profitability and being out-of-money is fairly common but only among firms which are in a phase of relatively higher growth. In order to understand the pehnomenon described above, one needs to understand that common measures of profitability are basically revenue less expenses (operating, interest, tax, selling and miscellaneous). This implies that the profitability of any firm is only an accounting measure. The amount of money (cash) that a firm possesses is determined entirely by what is known as the firm's Free Cash Flow (FCF). The FCF is calculated as shown below:

FCF = Net Income + Depreciation + After-Tax Interest Expense - Capital Expenditure - Changes in Net Working Capital

As is observable, the firm's cash position is impacted negatively by high magnitudes of Capital Expenditure and Changes in Net Working Capital (Working Capital Required). This should mean that capital expenditure leads to firms running out of cash which presumably is a bad thing. Hwoever, capital expenditure or equivalently investing retained earnings in business is one of the prime ways of ensuring business growth. In this context, capital expenditure is favourable. High growth firms need greater capital expenditure (higher investment of retained earnings) thereby implying lower FCF and even negative FCF (scenario of firm running out of cash.

Therefore, rapid growth is usually accompanied by firms running out of cash, even though profitability might be high (accounting measure of income).