What is Cash Cow?
A cash cow is referred to a company or an asset or a business unit that provides a consistent stream of cash flows by capturing large market share and requires a relatively lower amount of capital investment and maintenance cost. Products generated through the assets are standard and have a consistent growth of demand and therefore, provide higher returns at a lower risk.
- Cash cow forms part of the growth matrix of the Boston Consulting Group (BCG). The BCG divides an entity into four specific categories, namely, Star Category, Question Mark Category, Bull Category, and Cash cow category. This categorization helps the entity to determine the market share of the company in the specific sector. It further helps the company to analyze its SWOT (strength, weakness, opportunities & threats).
- Due to the standardization of production, the company can enlarge its production to maximize its market shareMarket ShareMarket share determines the company's contribution in percentage to the total revenue generated within an industry or market in a certain period. It depicts the company's market position when compared to that of its competitors. for the said product. Once the company acquires a higher market share, it can easily provide consistent returns.
How Does it Work?
It all starts with the incorporation of a company. The company makes divisions for their different products.
Let’s say one of the divisions of the Company is wristwatches. The sector for wristwatches is usually settled with a steady increase in demand. Let’s assume that this division manufactures only a particular type of wristwatch and captures almost 80% of the market share. It records a steady return on assets of around 28%. The sector for wristwatch grows at a steady rate of 4% every year.
In this case, this division of the Company is called a “cash cow”. A lower growth rate implies lower capital expenditure for assets. The ROAROAReturn on assets (ROA) is the ratio between net income, representing the amount of financial and operational income a company has, and total average assets. The arithmetic average of total assets a company holds analyses how much returns a company is producing on the total investment made. means the quantum of return earned using the cost of assets. The Company need not further invest in the said division.
As explained above, cash cows usually capture significant market share, and the industries are well established in the market. Large scale production implies lower cost of manufacturer, which in turn implies higher return on assets.
Example of Cash Cow
Let’s say a company has 2 divisions, namely steel wheels & alloy wheels. The details are as follows. The Company wants to identify the cash cow and its present potential. Also, calculate cash reserves for the next 5 years considering the growth of 3% for the steel division & 8% for the alloy wheels division.
Potential for next 5 years:
- The steel wheels division is a cash cow for the company since it has a lower growth rate, higher ROA & the largest market share in the sector.
- The alloy wheels sector is not a cash cow. However, as and when time progresses, the alloy wheel division can become one with a higher market share and higher returns.
Why are Cash Cows Important?
Each investment has an equal chance of gain or loss, i.e. 50% probability of risk. Investments are made to be risky. What if you produce something which has lower risk but high return?
Such investors are called as risk-averse investors who do not expect higher returns & are mainly concerned with lower risk. Cash cows produce sufficient support to the portfolio of such investors.
The cash flows generated are not required to be reinvested into the cash cow itself but are kept as reserves with the Company. It provides an additional hedge to the Company. The company can use such excess cash reserves for other business segments that require enormous funds at the initial stages. The company will be self-dependent for the required funding into new ventures.
- A stable rate of profits for the company.
- Creates real cash reserves for the company.
- Provides stable sales growth.
- Lower investment is required.
- Lower maintenance expenses are required.
- Assured higher returns than a normal venture.
- Increased consumer confidence as represented by higher market share.
- Increased market share.
- The lower number of competitors.
- The company can use these cash reserves to fund its other profitable ventures.
- The same quality is maintained for all products.
- Competitors have to price their products at a lower rate.
- No need to reinvest the cash reserves back into the cash cows.
- New entrants require large capital investments to capture the market share.
- Breaking the dominant role of the established units is not that easy.
- Achieving consumer confidence for new products in the same market is highly difficult.
- One new technology with lower capital investment for a new entrant is enough to break the dominant sector.
Cash Cows can also be called a “money plant” which requires minimal nourishment and yet provides consistent returns for the company. Even if they are mistakenly called “cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. ”, these undoubtedly provide sufficient cash reserves for the entity. However, any big change in the industry, considering human safety or environmental safety may drastically affect the sector as a whole.
This article has been a guide to Cash Cow and its meaning. Here we discuss how does it work along with their examples, advantages, and disadvantages. You may learn more about financing from the following articles –