Calculating Growth Can Save a Company from Trouble
How does a company with solid sales growth and increasing profits find itself in trouble? By not recognizing the integral connection between financial management and business growth programs.
History abounds with examples of companies that grew too fast, ran out of cash and failed. Even good managers who are enjoying sales and profit increases often fail to realize, until too late, the impact increased sales have on the cash flow required to finance corresponding increases in receivables and inventories.
Yet, as easy as it might be to blame a CEO for lacking in financial management skills, the issue is more complex than that. It is a matter of understanding and planning for the financial strain that accompanies growth. If management understands the relationships that exist between a company's financial structure and the strategic decisions related to growing the business, the chances of winning the survival game and sustaining the company in the long term are greatly enhanced. Out-of-cash, out-of-credit and out-of-capital generally results in an ugly situation, even if you have the best product in the world.
Every manager needs to know the answers to questions such as:
- How fast can we grow with our current financial resources?
- How much additional capital will we need if we want to grow by 30 percent this year?
- What are our financial limitations and boundaries? What is our cash flow break-even point? Have we planned for inventory purchases in September for Christmas sales?
- What is really driving the results in our business? Selling price? Volume? Product costs? How do changes in these factors affect profits and cash flow?
- How will our creditors and investors react to changes in these areas?
- What alternatives to manage and finance our growth plans are available? Which alternative is best?
The answers are more than a matter of spreadsheets and numbers. The key is to understand the linkages that exist between financial structure and business planning.
Drivers of the Business
In order to complete linkage, one must first understand what a company's business drivers really are. What makes the company "tick?" What changes make the most difference? What generates profit? How are existing assets and capital employed?
To identify key drivers, one must "drill down" through the numbers. Fixed costs must be segregated from variable costs. The true cost of goods sold must be determined, taking into account such factors as rebates, incentives and discounts. The impact of intercompany allocations must be identified, consistently considered and eliminated, if necessary. Contractually committed increases in labor expenses must be heeded. What happens if raw material costs increase or decrease? What if delivery times change? Are margins consistent across the customer base within a product line? Such questions should be applied to each area of the business.
As the company's drivers are identified, it can begin to quantify and forecast its performance under differing scenarios of pricing changes, sales volume increases or decreases, raw material and inventory costs, other cost reductions, capital expenditure decisions and other financial management alternatives. Then, financial performance ratios and resulting cash requirements can be calculated and benchmarks established.
Too often, a company will invest extensive personnel time and resources in the development of an elaborate forecasting model incorporating its business drivers, which proves to be useless later on because actual results cannot be monitored and measured against the forecasting drivers. For example, if revenues are determined to be driven by specific product line sales but the company's sales and accounts receivable information systems can track revenues only by customer, the opportunity to measure and monitor forecast performance vs. actual performance is lost.
Finding the Linkages
An important example of how traditional accounting and financial performance ratios relate to business strategy is in the determination of a company's sustainable growth potential‹its ability to grow before additional capital is required. Managers need to understand how each performance measure builds on the other; simply knowing the mathematical calculations and percentages is not enough.
Starting at the beginning, management must look at 1) the effectiveness of the company in generating a profit, 2) its efficiency in generating that profit, 3) the extent of debt financing employed and 4) its dividend policy.
Operating margin, or return on sales, measures a company's effectiveness at earning a profit and how the quality of the earnings process contributes to growth. But managers must also look at how efficient they are in generating revenues from net assets, including inventory (the turnover rate). These two measures of effectiveness and efficiency (margin and turnover) bring the income statement and balance sheet together in measuring corporate return or return on assets.
The return on invested capital (equity) can be determined by incorporating the transfer of financial risk to lenders through leveraging. Ultimately, it is a combination of the company's return on equity and its dividend policy that determines the sustainable growth rate of the company.
A Simple Example
Let's analyze the growth plans of XYZ Co. XYZ has been generating positive cash flow, and management has stated that its target growth rate is 26 percent. For the most recent fiscal year, return on net assets was 12.45 percent (assuming a hypothetical return on sales of 20.72 percent multiplied by a hypothetical turnover rate of 0.6 turns). XYZ is generally financed with equity and has a leverage factor (net assets divided by equity) of 1.07. The leverage factor multiplied by return on net assets, assuming no dividends are paid, results in a sustainable growth rate for XYZ of 13.29 percent, clearly in conflict with the desired growth rate of 26 percent.
XYZ's current financial structure will not support its growth strategy. The only way the target growth can be attained is for XYZ to seek additional debt or equity infusions, which would increase its leverage factor, or to increase its return on net assets through increased sales, higher net income or more efficient utilization of assets.
Significant analyses should be performed in determining XYZ's appropriate course of action. A thorough understanding of the company's key business drivers allows for a careful diagnosis of the individual factors that support a realistic sustainable growth rate. Will a pricing change result in increased sales? Increased profits? Should additional debt be added? Should the growth target be revised? Management can avoid disappointment (and possible disaster) now by working to align financial structure and strategies.
Linking Financial Management and Growth
Business performance responds to both qualitative (i.e., product quality, customer service and brand image) and quantitative (i.e., pricing, market share and cost control) issues. Management must understand how a growth strategy will affect cash flow, debt level, margins and profitability, return on equity and a company's ability to sustain its own growth.
The bottom line is the consideration of these factors:
- Will the company's financial structure support its business strategies?
- Will these strategies ultimately help the company achieve its financial objectives?
- Are these strategies or, for that matter, management's financial objectives consistent with the company's competitive position in the marketplace?