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The equation for Cash Flow after Investing Activities that was introduced in Chapter 1, modified to include the impact of interest income and interest expense (NetInt), is:

[2-2]CFaIA = NI + D & A ± NetInt ± ΔWC − Investments

Usually investments are considered to be a “positive” or a good thing for a business. To accommodate this notion Equation [2-2] can be rewritten as:

[2-3]CFaIA = NI − (Investments − D & A) ± NetInt ± ΔWC

Now, when Investments > D & A, the term (Investments − D & A) is positive. The term (Investments − D & A) is also known as “Net Investments” where

[2-4]NetInvest = Investments − D & A

Substituting NetInvest for the term (Investments − D & A), Equation [2-3] becomes:

[2-5]CFaIA = NI − NetInvest ± NetInt ± ΔWC

The magnitude and sign of the Net Investments term is of interest because it may give an indication of what's going on with the cash flow–producing assets of the business. For example, three ways of looking at this term are:

1. If Investments = D & A, then the net investment is zero. This may indicate the company is replacing its cash flow–producing assets at the same rate as they are wearing out or being depleted.

2. If Investments < D & A, then the net investment is negative (adding to the Cash Flow) and the cash flow–generating assets may not be being replaced as quickly as they are being written off.

3. If Investments > D & A, then the net investment is positive and the management team is making investments that in total are greater than the sum of depreciation and amortization and thereby increasing the company's future cash flow–generating assets.

However, a lot of other things could also be going on. For example: If NetInvest equals zero, it doesn't necessarily follow that the cash flow–producing assets are simply being replaced. It could be that the existing assets aren't in need of replacement and the investments that are being made are intended to generate future cash flows from another product line or service. Similarly, if NetInvest is negative, it could signify that once again there is no need to replace all existing assets at the rate they are being depreciated. It could simply be that the investments being made are for a new product line or service but the investment is less than the depreciation of assets on the books. Finally, if NetInvest is positive, it could signify that existing assets are being replaced with assets that have more capacity or the assets aren't being replaced at all but rather the investments are in a new product line or service or investments are being made at an accelerated pace for a period of time.

The point is: The term NetInvest only indicates the magnitude of investments being made relative to the depreciation and amortization that is taking place. It also quantifies the net magnitude of expenditures that will have an impact on Net Income and Cash Flow for many periods. In and by itself, it doesn't say anything about the kind of investments that management have chosen to make.

For this reason there is also a need to focus and understand investments that are being made and not reflected in the definition of Investments (capitalized investments) but can have an impact on Revenue, Net Income, and Cash Flow.

Investments that are typically capitalized and depreciated over time are:

• New plant and equipment: Maintenance can perhaps extend equipment life indefinitely. However, at some point it becomes inefficient. In addition, equipment manufacturers are continuously improving their product. This results in the next generation being able to perform better, cheaper, and faster. Equipment is purchased for various reasons. Whether it represents a replacement for a worn-out machine or new technology, it is an investment.

• New or upgraded software: While there aren't any technical reasons why software can't last forever, developers continue to develop more powerful releases and new applications. This results in decisions to discontinue factory support for older versions. Upgrading isn't a trivial project. Systems that control the enterprise or parts thereof are very sophisticated and any change involves risk. To offset this risk considerable planning takes place, which results in detailed implementation plans that can turn upgrades into a major investment.

• Acquisitions: Growth strategies are often based on acquiring cash flow, products, technologies, companies, and so on, which involve goodwill, non-competes, patents, and so on, all of which represent an investment.

Expenditures that are not capitalized because the expected result is too difficult to quantify over time are:

• Research and development: In most companies it's mostly “D” with little “R” and when R does exist it is usually “r.” In well-run organizations the R&D budget represents an investment in products, services, and cost reduction.34

• Quality control program: This is an investment in cost reduction, risk management, and happy customers.

• Productivity program: Companies cannot count on price increases to offset cost increases. To maintain or improve gross margin, a company has to continuously invest in improving its productivity.

• Marketing: Depending on the organization this can be large “M” or small “m.” Be that as it may, marketing represents an investment in placing the company's product or service top of mind with consumers.

• Sales: This may not traditionally be considered an investment, but it is one nevertheless. Whether the contact is in person, by telephone, or via the Internet, the objective is always to get an order for a product or service at an attractive price from either new or repeat customers in existing or new markets. This doesn't just happen. To capture the customers' wallet takes an investment in time and money.

• Administration: Investments are made all the time in this area in both people and systems. The objective is to provide efficient infrastructure and services to the various operating entities. To do so, a company must continually strive to be best in class and this takes resources that require investments.35

• Lawyers: While not always viewed as such, the legal profession has a role to play, and experience has shown that it pays to invest in legal advice up front as opposed to fighting it out in court.36

• Accountants: This is an investment by the owners of the business in getting an independent assessment of the company's financial condition, and for public companies is a legal requirement. In addition, management will often call on accountants for specialized advice on such things as improving the control environment and minimizing taxes. Both of these represent value to the business. The first reduces risk by providing advice on best practices. The second results in more after-tax cash flow.37

• Investment bankers: Companies frequently require capital and such services as strategic advice. Bankers provide these (and other) services for a fee, which can represent an investment in improving the capital structure of the company and/or maximizing shareholder value by considering various strategic alternatives.38

The list goes on. The point is: Investments are not merely expenditures that offset depreciation or amortizing assets. Investments, in the context of this discussion, include select items in several categories.39

[2-6]Investments = Property + Plant + Equipment + Software + Acquisitions + Intangibles + Operating Investments

So, in summary, Investments are not merely the difference between the D&A of existing assets and expenditure on like kinds of assets. They include those just discussed and much more. However, to simplify the discussion, the investments discussed in the context of Net Investments refer to investments that are capitalized, such as facilities, equipment, and software.

Since Investments are what ultimately drive growth and cash flow, the rate at which they are made is of interest. For example, if a project that involves $1,000,000 of investment is completed in three years, its impact on the company's growth will be different than if it was completed in two years, all other things being equal. Hence, the rate at which a company invests money or the “Investment Rate” is a concept that needs to be explored.