Don't "Grow Broke": Overcoming the Dangers of Poorly Managed Growth
Good news! The economy is growing again. However, expanding businesses are often in greater peril than those that have suffered through a challenging economy and declining revenues. The often misunderstood truth is that it costs money to grow.
Business owners who don't understand this end up fulfilling their higher sales dreams, but often at the cost of bankrupting their company. How can you prevent this? A great place to start is understanding the concept of "Financial Gap," the difference between the money you have and the money you need to grow.
Why does growth cost money?
As your sales grow, your company needs new assets to support those increased sales. By using the Financial Gap tool and calculating the present efficiency of your operation, you can predict with great accuracy what you will need in new assets to support increased sales. For most business owners, this is almost counter-intuitive. It is your increased sales--specifically buying the assets to support them--that causes you to run out of money while you are growing.
There are only four sources of money to grow a business:
- New equity from the owner. This is not a popular choice! The object of most businesses is to get more money out, not put more money in.
- Trade credit. These are the "free liabilities" from your vendors. The usual duration of such a happy arrangement is about 60 days. After that, this source of capital immediately dries up, and you are now on COD.
- Retained earnings. Retained earnings are usually low because we hire an accountant to make them low so we don't have to pay taxes. It is the very rare company that has enough profits to support sustained growth in an expanding business.
- The bank (leasing companies, credit cards, etc.). When a business owner comes to the bank to ask for a loan, the banker knows that you are out!
How much do you need to grow?
This begins with understanding the concept of "variable assets and liabilities" inside your company. As your sales grow, you need increased assets to support the increased sales. The two most common variable assets in most businesses are inventory and accounts receivable; and the most common variable liabilities are accounts payable.
Using "percent of sales" as the calculation process, you can quickly determine what you have in variable assets and liabilities to support your current level of sales. The next step is to understand that for every increased $1 in sales, you will need that same percentage of variable assets and liabilities to support that increased sales dollar if you are operating at the same level of efficiency as before.
Using this process, you can quickly determine what will be required in assets and incurred in new liabilities to support your increased sales. When you total those numbers, the remaining balance is the "financial gap" that will be required from an outside funding source to support your increased sales.
The dangers of mismanaged growth
In our Profit Mastery case study examples, we start with a company that has just completed sales of $600,000 in the previous year and has a very strong balance sheet. We then project sales of $900,000, then up to $1.6 million in one year. We learn that if the company continues to operate at the same level of efficiency, the amount of bank debt required to fund the increased sales rises significantly. If sales increase to $900,000, the business will need $126,000 in additional funding, and if they "shoot the moon" and grow to $1.6 million in revenue the business will need $462,000 in new bank debt to fund it. Even more critical, the balance sheet of the company grows significantly weaker, substantially increasing the risk to the owners.
What makes the Financial Gap such a critically important and useful financial tool for business owners is that it takes very little time to do these calculations; and then you can do projections at various levels of sales to see what level of growth you could actually sustain with both your internal financing capabilities and your bank relationships.
We complete the case study by taking the $900,000 company and better managing the two most important variable assets--inventory and accounts receivable--and we are able to self-fund the growth through internal cash flow. We complete the case study with a balance sheet even stronger than it was at the $600,000 sales level, driving up revenue and profits and actually reducing risk to the owners.
Every business owner needs to understand and be able to implement this financial tool, especially if they are in a period of aggressive growth. If your franchise network is in a growth mode now, be sure that you understand Financial Gap and have identified the sources of money to fund the growth--and don't "grow broke."
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