Managing cash flow through growth
Growing a company is about growing value for the owners and shareholders. The logical extension of this thinking is that success is ultimately determined by the size that a company grows to. The bigger the company, the more successful it is considered to be.
To fulfill the destiny of increased value, many companies will focus on top line growth. This often comes in the form of a marketing campaign that is designed to attract new customers, and hopefully get existing customers to buy more. Success is demonstrated through an often impressive increase in short term sales.
But does top line growth truly demonstrate success?
Let’s go back to the foundation: growing a company is about growing value for the owners and shareholders. True value lies in having long term sustainability, not in short term gains. On paper, additional sales look great as they boost profitability (depending, of course, on how efficient the company is at managing its expense-to-earnings ratio). But, if those additional sales come at the cost of an efficient cash flow, then the company may find it difficult to replenish assets and take advantage of emerging opportunities.
Reward versus risk
Growth in sales is the classic reward versus risk scenario. The reward is increased sales, and increased profits. The risk is the significant investment into the assets required to generate the growth, which have to be funded regardless of whether growth is achieved. Any growth in sales requires an increase in assets that support ongoing business operations.
The most important question that a business needs to answer about growth is: what impact will this growth have on the underlying value of the business?
A simple, visual, way to determine this is by plotting a graph that shows the current Earnings Before Interest & Tax (EBIT) of the business, relative to the current Net Operating Assets (NOA). Then, plot the increase in EBIT that is expected as a result of growth in sales.
The general expectation is that growth in sales reaps significant benefits in profit. However, assuming there are no changes to the underlying efficiency and operation of the business, that same growth in sales will require an increase in assets to enable it (see diagram A, below).
Diagram A: growth in direction A requires an increase in Net Operating Assets to a level that adequately supports the projected growth in Earnings Before Interest & Tax.
Scoping out growth
Growing sales in this way can be effective, assuming that the business has an adequate supply of funding. However, because the case is often that new funding is needed at a faster rate than profits are generated on historical sales, some businesses may find that they suffer a cash squeeze.
When planning for growth, the optimal approach is to grow sales, but keep assets at the same level (see diagram B, below). This requires some forethought about how to sweat the existing assets, making themall more efficient in the generation of profit. If this can be achieved, then the reward (EBIT) is achieved, without the risk (increased investment in NOA). Of course, this is difficult to achieve unless the business already has excess capacity in its assets. Aiming for somewhere between directions A and B will give the business a stronger working capital.
Diagram B: growth in direction B requires a structured approach to sweat the existing assets.
The magic in growth lies in an increase value to owners and shareholders of the business, not just in an increase in sales. When planning for growth, graph out the planned trajectory of the growth, and then consider how to effectively sweat existing assets. This opens the door for increase profitability through additional sales, whilst retaining a strong working capital.
Written by The Westpac Davidson Institute. Get more information on the Davidson Institute and financial education resources here.