No matter what the economic environment there is always an opportunity for growth. Unfortunately, we don’t always take advantage of that opportunity whether we want to grow to become the biggest player in our chosen market. Grow to keep pace with inflation or somewhere in between we need to focus on the critical enablers that help make that growth possible and more importantly help make that growth both sustainable and profitable for us over a long run.
Growing a business is an exciting time, the phone is ringing off the hook, the staffs are working double time to fulfill customer request and there are generally plenty of pats on the back and big grins about the wonderful opportunities that growth will bring to the business.
When growth happens either by chance or design it is common for business owners and managers to jump right into the thick of the action without stopping to consider the implications for the future sustainability of the business. Growth can be a fantastic thing for business bringing significantly extra profit and returns for the business owners. However if not managed well it can also put a lot of strain on a business.
Let me tell you about the experience of a mate of mine Adam. Adam runs a small business selling tiles and has done so for the past 6 or 7 years in the early days profits were good and the business was operating smoothly. Now Adam is one of these guys that has the gift of the gab and is a natural salesman.
After a few years, his hard work had driven sales growth up by about 30% per year. Each time we met his smile was bigger and bigger but then a couple of years ago Adam ran into Cash Flow problems. He didn’t understand why cash was so tight even though sales were continuing to grow and grow. What Adam hadn’t banked on was the fact the rapid growth chews up cash and needs to be managed well for the business to be sustainable in the long-term.
A critical enabler of success not just for Adam but for all of us in business is the ability to measure the performance of our growth in a meaningful way. Let’s take a look at 3 key areas. Firstly, we look at our strategy for growth and determine what success looks like. If you don’t do this, how would you ever know if you reach where you wanted to go? Secondly, look at some simple key performance indicators that will tell us when we’ve achieved that success and thirdly we’ll look at some of the levers that we can use to get the best out of our growth. By understanding the key elements or all those forces that drive growth we can develop a growth strategy that has a better chance of achieving success.
There are generally two different approaches to how we manage growth within our business. We can either choose to be active in our approach to growth or passive.
Active growth is where we strategically plan to increase our sales to capture additional value for our business. This involves us setting up data points using whatever data is available about our business performance and the market environment, compete with our competitors and grow our market share.
When done well active planning for growth can have significant value. Passive growth comes in 2 flavors either we are growing at the pace with inflation which simply means that as our suppliers raise their prices we raise ours thus increasing our sales revenue. Alternatively, we undergo unplanned growth where all of a sudden we have additional sales coming in. There are plenty of reasons that businesses can experience unplanned growth, many of them related to changes in the external marketplace such as the availability of new technology, a competitor going out of business or even natural disasters.
In practicalities the ultimate price for growing our business is profit. To achieve that profit we often look to increase sales. However, there could be problems lurking in the background in fact instead of turning over a profit the best way to think about our growth is to start with our customers. The only way that we can generate new sales is by getting our customers to buy what we have to sell. This leads us to think about we need to have available in order to satisfy that customer’s demand. Typically, we need to have more stock for them to buy. Then we may need to take on extra staff, purchase new equipment and if sales growth is strong enough we may even need to move into a larger space. All these activities cost money, be it the commitment to actually spending the money. In actuality, this happens well and truly before our customers have even made the purchase which is why businesses that experience rapid growth often find themselves short of cash.
Let’s look at it this way, to generate the desired profit level, we needed to have a certain amount of assets, assets that we need to fund such as all of the stock, plant, equipment and so forth that is necessary to create and distribute our goods and services.
Growth in sales requires an increase in the assets that support our operations which means all things being equal if our growth follows the same trajectory then not only do our sales and profit increase but so too does the amount of funding required to support our activities. If we have not planned for growth or have taken a passive stance then this is likely to be the outcome of course this is where the phrase “growing yourself into trouble” comes from because for every dollar you make in profit it is costing you in the form of your net assets which is in a fact your cash flow.
This is pretty much what was happening to my mate Adam, when his business was growing and why he was running out of cash. What we need is a way to take advantage of the growth and not have it blow out our cash flow in the process. It’s not all bad, depending on how you manage your sales and required assets there can be a number of different outcomes. It may be you can increase your sales without increasing your assets, usually achieved if you have excess capacity in your assets or you can outsource only what you need.
Optimize growth is when we get sales to increase and use less assets in doing so. How is this possible? Increase productivity, find a way to use your assets more productively. This is a short-term strategy, quite often it is not sustainable in the long-term.
There are also instances when sales grow, assets grow but your profit doesn’t. This is a business a the state of declining growth, your costs are growing faster than your sales. This is not a place you want to end up, financial stress and pressure is heightened as a result of your sales growing, your assets growing but your profit goes backward. If you find yourself here it may be a good checkpoint to think of getting out of this business.
Given all the different ways to go, where should you be aiming for? The preferred way is in the wedge between optimize growth and maybe slightly even into declining growth. In fact, optimize growth and declining growth are usually short lived. We should be looking for more long-term strategy, the fast growth section. Nearly all directions except optimized growth require more assets more assets means you will need more cash to fund your business. Whether actively or passively growing our business we’ll want to capture as much value as possible by increasing our profits and minimizing the additional expenses associated with generating that growth. The question is how do we do that
Through the use of success scorecard. The old age saying, by Peter Drucker “We cannot manage, what we don’t measure”. Firstly there are 3 questions to ask ourselves.
How much do I need? Where will I get it? And do I like the picture I am painting? I am going to show you a method for identifying how much capital or cash may be required to support your growth so that you can then make more informed decision on where to sort that capital.
Then develop scorecards so that you can measure the success of your growth in terms of profit margin, return on investment and risk debt to worth.
To understand why these are key metrics when we are growing our business we need to understand how the business operates financially. To understand this better we’re going to use a model called the financial operating cycle. Imagine for a moment that we just opened a business together now contribution to funding the business is called our equity or net worth, this is money for our own pockets in effect.
We can borrow the money. The money we borrow (liabilities) together with our money and the money that we borrow to make up all of those resources that we have available to operate our business and we operate the business by purchasing/paying for assets. Collectively the equation, assets equals liabilities plus net worth is our balance sheet. Our balance sheet is the single most important financial document we have in terms of measuring the success of our growth. When we purchase assets we’ve done so to operate our business and create sales. Our grandest hope is that we can convert those sales into profit through the efficient management of our variable expenses and overheads.
This portion of the financial operating cycle leads us to what is represented in our income statement or profit and loss statement which is our traditional method of judging our success. This is where I find most business owners stuck, they focus and stop at profit but profit is only one measure of success.
The key lies in the next step, which is to consider how their profits can be used to drive even more successful outcomes within the business. In effect, our profit serves 3 masters within the business. Firstly it serves the business by helping us purchase more assets secondly it serves our creditors by helping us reduce how much we owe them and finally it serves us as the owners and investors in the business by paying us a dividend use properly.
In the correct proportions, we can successfully grow our business in such a way that we can avoid some of the more strenuous growth pains. By understanding this flow of funds through a business we can see that everything is interconnected and that a growth in profit that we are all chasing is going to impact other parts of our businesses as well.
Now, we’re going to use this agreed understanding to get some foresight into the impacts of growth. One of the most important things that we can do to understand the impact of growth is to determine what our balance sheet would look like after we’ve grown our business. We call this finding the financial gap or in practical terms identifying how much additional money we need to fund the growth in profit that we are trying to find.
Here’s how it works, let’s say that last year we had a little business that makes $1 million in profit let’s also say that they are making a 20% profit margins at this point in time. So in order to make that $1 million in profit we needed to generate $5 million in actual sales. In order to generate these sales, we need assets.
Assets come in two flavors, firstly we have short term assets which include all of the stock that we hold any work in progress that hasn’t been billed out to our customers just yet and all outstanding invoices that our customer owes us.
Secondly, it also includes any fixed assets such as plant and equipment that we need to make sure the sales happen. For example, in order to generate $50 in sales we use assets worth $100. We know that on the balance sheet the assets must equal the combined total of liabilities and net worth. Right now we don’t owe any money to anyone everything invested in a business is our own money so with no liabilities we have $100 in net worth. Now let’s say we want to grow the business and that we’re going to double our profits in the next 12 months. What will be the impact? Well, let’s work through the logic.
If we are doubling the amount of profit we want to make, all things being equal we will need to double the amount of sales to make. Instead of making $50 in sales we now need $100 in sales same with assets instead of holding $100 of assets to support sales because we are doubling our requirement we now need to hold $200 in assets. All straightforward so far right, we have based our business will be operating at the same level of efficiency as previously.
Here’s where it gets interesting, in our original example we started with no liabilities and had invested $100 of our own money into the business. Now we need $200 in assets what we currently only have $100 in funding where do we get the rest from? It will partly come from our profits let’s say we reinvest all our profit back in the business giving us a net worth of $120. But we are still short we still need another $80 this is the financial gap in a very practical sense that $80 is the cost to where our business are growing and we should think about it in this way how much do we need to spend in cash flow and funding in order to grow our business.
By planning out the likely impact of growth we have a much better chance of controlling the outcome and capturing true value from it. What we have done with this financial gap analysis it simply answers the first of the three very important questions:
Ø How much funding do we need?
Ø The second question is where will we get the funding from?
Ø And the final question and by far the most important question is do we like the picture that we are painting for ourselves?
Remember this is just a plan if you don’t like it you can change it.
Now that they have identified the financial gap again start to answer the second question where will we get it? There are four main ways that we can fund growth or fill in the financial gap. Remember the balance sheet assets equals liabilities plus net worth. We can fund the gap either through increasing our liabilities or by reaching once again into our own pocket and increasing our equity. Increasing our liability involves either taking on more debt such as borrowing from the bank or better leveraging the invoice terms of our own suppliers. In other words holding on to those invoices until the last possible payment date and using the funds to support our growth. Increasing our net worth involves either reinvesting any profits that we make into the business or putting in more of our own money or seeking an equity partner. By calculating the financial gap and exploring the sources of the funding to fill that gap we can make more informed decisions regarding growth.
To answer our third question to highlight the picture that I’m painting, you need to develop a scorecard and measure our success. In effect, we need to determine if the amount of profit that we need to generate is actually worth the amount of money we need to spend in order to get it in the first place.
We can measure a lot of different things to determine our success and there aren’t really any right or wrong answers here, however, there are four really good measures that can help us determine whether or not we have achieved what we wanted to.
Firstly, there is the old yardstick of profit-Are we making more money? And if so how much? It is always good to measure this in both dollar terms and percentage in percentage terms, after all, we don’t want to grow the business but lose the margin at the same time because we will be working harder not smarter. In our example, if we were aiming for a 15% net profit margin.
The second measure we can use is asset efficiency this is where we determine how effectively we are using our assets to create sales and revenue. A low number here tells us that our assets aren’t working hard enough. That might be an indication that we have too much stock or too much capacity. The aim here, of course, is to use our assets as efficiently as possible in generating sales.
Thirdly, we can measure return on investment by looking at the profit we are making in terms of the funds that we are invested in the business gives us a sense of how much value that we personally are getting out of the business. What is our return or reward for the risk we are taking in this example we are making a 16% return on our $120 investment? Finally, if you are going to measure return on investment or our reward we need to compare that with our risk via the debt to worth ratio.
Debt to worth measures how much the funding we are putting into the business vs. how much are we borrowing. In this example for every dollar that we’ve invested, we have borrowed $0.66 which is a very fairly low-risk scenario. A more common scenario is that growing businesses use a lot of debt to fund their growth which significantly increases their risk. By developing this scorecard for our business we can explore different scenarios for what we want this picture to look like as our business grows. We can then determine what levers we need to maneuver to achieve our desired outcome.
Let’s focus on what levers we can pull within the business to improve the success of our growth. If we can improve the operational efficiency of our business we can reduce the cost of growth which gives us more access to the values that we are hoping to capture. This section is focused squarely on asset efficiency. Earlier we looked at the fact that a growth in profit is often accompanied by a growth in assets. But that the optimal way to grow profit is to use our assets more efficiently regardless of the industry that we are in. There are a number of levers that we can pull which had a direct and beneficial impact on our business. By focusing on our balance sheet and identifying the different techniques available to us to improve our cash holdings. We can become more efficient and generate the cash, support our growth internally.
Let me finish with giving you a list of just five things that we can do to improve the efficiency of your balance sheet.
Ø Firstly, speed up debt collection. Every day that our invoices remain outstanding is an additional day that we do not have access to our cash by implementing effective procedures to shorten the time it takes our customers to pay us we start getting access to our cash quicker which will help us to drive our growth more effectively.
Ø Secondly we can speed up our stock rotations or our work-in-progress if you have a service business by turning over our stock more quickly or by getting the jobs done more quickly we are freeing up cash that gets tied up here.
Ø Thirdly, we can improve the productivity of our fixed assets consider things like how we utilize the space in our premises. Is there an opportunity to generate a greater return from currently underutilized space or plant and equipment? Is our plant and equipment getting the job done efficiently? Are our people trained and motivated to get the best out of their equipment? Are our people sitting in the office or activity out doing work for clients and billing them for it? An important thing to note, there is so much growth for productivity improvement when we actually focus on it.
Ø Fourthly, we can sell unproductive assets these are either old assets that we don’t use anymore which can be turned into additional cash or they are assets that we currently use but which are under performing. If they are underperforming they may be costing us more money than they are worth.
Ø As a fifth lever we could choose to curtail expansion.
In that equation the final question, we asked ourselves do we like the picture that we are painting for our business. If not then we can choose not to grow or we can choose to grow at a slower pace one that is not going to decimate our cash flow and our balance sheet.
It is important to know that these are not the only 5 things that you can do. But they are a great place to start. By far, implementing the above efficiency measures in conjunction with others methods and approaches that might specifically relate to your own business operations. You can definitely manage growth. This is the real key to growing successfully.
Email us at firstname.lastname@example.org or call 07 3668 0646 if you need assistance and support with your small business from start, scale thru to sale.
James Huy Vuong is a CPA and the owner of Your Accounting Partners. Partnering with businesses from start to scale thru to sale.