Managing business growth.

Hi, I’m Rob Lockhart from Westpac’s Davidson Institute here to talk to you about ‘Managing business growth’.

The reason I think it’s important to talk about managing business growth is because no matter what the economic environment there is always opportunity for growth somewhere. However, 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 key drivers that help make that growth possible.

And more importantly, help make that growth both sustainable and profitable over a long period of time.

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 a business, bringing extra profits and returns for the business owners, however if not managed well it can also put a lot of strain on a business.

Particularly rapid growth. Rapid growth chews up a lot of cash and needs to be managed well for the business to be sustainable in the long term.

The key to growing successfully is being able to forecast the impact of growth on a business. This video address three key areas to be mindful of when growing your business. Firstly, we will have a look at a few different growth strategies, and what successful growth might look like. Secondly, we will look at a way of measuring the impact of growth on a business and whether that growth is sustainable.

Thirdly, we’ll look at some of the levers that we can use within the business to make the most of growth opportunities.

In the first section of this video, we are going to explore the strategies behind growing a business. There are two different approaches to how growth can be managed in a business. You may be active in your approach to growth, or passive.

Active growth is where you strategically plan to increase your sales to capture additional value for the business. This involves using whatever data is available about your own business performance, and the market environment, to challenge your competitors and grow your market share. When done well, actively planning for growth can be of significant value.

Passive growth comes in two flavours. Either you can grow at pace with inflation, which simply means that as your suppliers raise their prices, you raise yours, thus increasing sales revenue. Or, you might experience unplanned growth, where all of a sudden you have unexpected additional sales coming in. There are any number of reasons that a business can experience unplanned growth … many of them related to changes in the external environment .

Such as the availability of new technology, a competitor going out of business, or even natural disasters.

If you haven’t planned for growth, you may not be in a position to harvest the full value that growth may offer. In fact, it may even be detrimental to your business. Let’s take a moment to explore why that might be so.

The ultimate prize for growing your business is of course more profit. To achieve that profit, we often look to increase sales, however to do that we’re going to need more customers buying more of our goods or services. So, the key question to ask yourself is, “what are all of the things that we need to have available to satisfy increasing customer demand?”

Typically, you’ll need to have more stock for them to buy and the capacity to support those customers as debtors. Then, you may need to take on extra staff, purchase new equipment and, if sales growth is strong enough, you may even need a larger space. All of this costs money, and here is the rub … you need to spend that money before your 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. The upward diagonal arrow on the screen represents an example of Sales growth … a nice steady increase over time. The graph shows that at point A there is a certain amount of Profit being made, shown on the left-hand axis, and a certain amount of Assets being used, shown on the bottom axis. This is commonly the way growth occurs within a business, but it doesn’t have to be. In fact, it isn’t even the most optimal outcome.

Let’s say the business is going to grow its Sales by 10% next year moving up the line to point B. If the business continues to manage its costs and Assets at the same level of efficiency, then the expectation would be that Profits would increase by 10% and Assets would increase by 10%. However, if the $ amount of extra Profit is less than the $ amount increase in Assets then the business will need to find extra money from somewhere else to fund the increase in Assets.

It is the gradual increase in Assets that is using up cash in the business.

If you haven’t planned for growth, or 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 Assets, which is impacting your cash flow. What’s needed here is a way to take advantage of the growth, and not have it blow out cash flow in the process.

However, depending on how you manage your Sales and required Assets there can be a number of different growth outcomes. It may be that you can increase your Sales without increasing your Assets. I call this ‘Fast growth’ and it can usually be achieved if you start using excess capacity in your Assets or start outsourcing work that utilises more Assets.

What would be wonderful is if you could increase Sales but use less Assets. I call this ‘Optimised growth’. This might occur if you find a way to use your Assets more productively, but often it is not sustainable in the long-term. There are also instances when Sales grow, Assets grow, but your Profit doesn't. I call this ‘Declining growth’. Your costs are growing faster than your Sales.

Where you really don’t want to end up is in ‘Financial stress’. Where your Sales grow, your Assets grow but your Profit goes backward. If you find yourself here it may be time to think of making some significant changes. Perhaps even getting out of the business is you don’t think you can reverse this trend.

Given all the different ways to go, where should you be aiming for? The preferred ways are Optimised growth, Fast growth, and maybe slightly into declining growth for a short period. Optimised growth and declining growth are usually short-term phenomena. The optimal long-term strategy is Fast growth.

Remember though that nearly all outcomes, except optimised growth require more assets. More assets means you will need to find more cash to fund your business growth.

In order to make the most of a growth opportunity it’s important to understand what impact the growth will have on the business. In this section of the video, we will explore how to forecast and measure the impact of growth. We are going to ask 3 questions: • How much do I need? • Where will I get it? and • Do I like the picture I am painting?

I’m going to show you a method for calculating how much capital may be required to support your growth so that you can then make a more informed decision on where to source that capital. Then we’ll develop a scorecard so that you can measure the success of your growth in terms of profitability, efficiency, reward, and risk so you can make more informed decisions about growth opportunities.

Firstly though, we need to understand the way money flows through a business. To do this we’re going to use a model called the Financial Operating Cycle. Imagine for a moment that we are opening a business together. Our contribution to funding the business is called our Equity, or Net Worth. This is the money from our own pockets. We combine that with money that we borrow, our Liabilities.

Together, our money and the money that we borrow make up all of the resources that we have available to operate our business, and we operate the business by purchasing Assets. Collectively, this equation, Assets = Liabilities + Net Worth, is our Balance Sheet, or the business’s Statement of Financial Position.

When we purchase Assets, we have done so to operate our business, and generate sales. Of course, our aim is to convert those Sales into Profit through the efficient management of Expenses. This portion of the Financial Operating Cycle represents our Income Statement. This is where I find most people stop … Profit is their one measure of success. However, the next step is to consider how that Profit is then used. Essentially there are 3 uses of profit.

Firstly, it can be used to purchase more assets to help the business grow. Secondly, it can be used to reduce liabilities, and finally, it can be taken out of the business and paid to the owners. The key to longevity in business is to keep this cycle turning over smoothly and efficiently.

By understanding this flow of funds through a business we can see that everything is interconnected and that the growth in profits, that we are all chasing, is going to impact other parts of the business as well. We are going to use that understanding to gain some foresight into the impacts of growth.

Remember growing Profits, or growing Sales, more often than not means needing more Assets – which are part of the Balance Sheet. One of the most important things that we can do to understand the impact of growth is to determine what our Balance Sheet will look like after we have grown the business. We call this ‘finding the financial gap’, or, in practical terms, identifying how much additional money we need to fund the growth that we are trying to achieve.

Here’s how ‘finding the financial gap’ works. Let’s say that last year this little business made $10 in profit. Let’s also say that they’re making a 20% Profit Margin at this point in time. So, in order to make that $10 in Profit, they needed to generate $50 in Sales. To generate these sales, they used Assets. Assets come in two flavours.

Firstly, there are short-term, or current, Assets which includes things like Stock, any Work in Progress that hasn’t been billed out yet, and any outstanding invoices that customers haven’t yet paid.

There are also Fixed Assets, such as Plant and Equipment, that are needed to make sure the Sales happen. So, in this example, in order to generate $50 in Sales, they used Assets worth $100. On a Balance Sheet, the Assets must equal the combined total of Liabilities and Net Worth. Right now, this business doesn’t owe any money to anyone else – everything invested in the business is their own money. So, with no Liabilities, there is $100 in Net Worth.

Now, let’s say they want to grow the business and are aiming to double their profits in the next 12 months. What will be the impact? Well, let’s work through the logic again. So, to double the amount of Profit, all things being equal, they’ll need to double the amount of Sales made too. Instead of making $50 Sales, they now need to make $100 worth. Same with Assets.

Instead of using $100 of Assets to support Sales, they now need $200 of Assets. All straightforward so far, and all based on the fact that the business is operating at the same level of efficiency as previously. Here’s where it gets interesting, however. In the previous year they had no Liabilities and had invested $100 of their own money into the business. They now need $200 in assets, but we currently only have $100 of investment in the business. Where does the rest come from?

It will partly come from profits. Let’s say all the profit is reinvested back into the business giving a new Net Worth of $120. But they’re still short. They still need another $80. That is the ‘Financial gap’. In a very practical sense, that $80 is the cost to the business for growing.

What we have done within this ‘Financial gap analysis’ is simply answer the first of those three very important questions, “How much funding do I need?” The next question is then “Where will I get that funding from?” The final question, and by far the most important question, is, “Do I like the picture I’m painting? “

Now that the ‘Financial gap’ has been identified you can start to answer the second question, “Where will I get it?” There are four main ways that you can fund growth or fill in that ‘Financial gap’. Remember the Balance Sheet - Assets equals Liabilities plus Net Worth. You can fund the gap either through increasing your Liabilities, or by reaching once again into your pockets and increasing your Equity or Net Worth.

Increasing liabilities involves either taking on more debt, such as borrowing from the bank, or better leveraging the invoice terms of your creditors. In other words, not paying those invoices until the last possible payment date and using the money still in your business to support growth. Increasing Net Worth is either reinvesting any profits back into the business, or the owners putting in more of their money, or seeking another investor or equity partner.

Calculating the ‘financial gap’ and gives you the opportunity to explore the different sources of funding to fill that gap to help you make more informed decisions regarding growth.

To answer the third question, “Do I like the picture that I am painting?”, we’ll develop a scorecard to measure the impact of growth. In effect, you need to determine if the amount of profit that you want to generate is actually worth the amount of money you need to spend to get it. There are four really useful measures that can help you determine whether or not you’ve achieved what you set out to.

We’ve used the numbers from the earlier ‘financial gap’ calculations in these examples. Firstly, there is the old yardstick of Profit. Are you making more money, and if so, how much? It is always good to measure this in both dollar terms and percentage. After all, you don’t want to grow the business but lose margin at the same time, because you’ll be working harder, not smarter. They achieved a 20% profit margin which is consistent with their budget.

The second measure to use is Asset efficiency. This is where you can determine how effectively you’re using Assets to create Sales. A low number here tells us that the Assets aren’t working hard enough. That might be an indication that there is too much Stock, or too much unused capacity in your equipment. The aim here of course is to use the Assets as efficiently as possible in generating Sales.

Thirdly, measure return on investment. By looking at the Profit you’re making in relation to the money that you have invested in the business, gives an indication of how much value you’re getting out of the business. What is your return or reward for the risk you’re taking investing in the business? In the example they’re making a 16% return on their $120 investment.

And that’s the final measure – Risk. The Debt to Worth ratio measures how much funding the owners are supplying to the business, versus how much they’re borrowing. In this example, for every $ invested they’ve borrowed 66c which is considered a 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 little scorecard for the business, you can explore different scenarios for what you want your ‘picture’ to look like. You can then determine what levers you need to manoeuvre to achieve your desired outcome.

In the final part of this video, we are going to focus on what levers can be shifted in the business to improve the success of growth. If you can improve the operational efficiencies of your business, this can reduce the costs of growth, providing you with more value from your growth. Given that Assets are such a critical element of growth, this section is focused squarely on asset efficiency.

Earlier in this video, we looked at the fact that growth in Profits is often accompanied by growth in Assets, but that the optimal way to grow Profits is to use Assets more efficiently. By focusing on the Balance Sheet and identifying the different techniques available to us to improve cash holdings, the business can become more efficient and generate more cash itself to support growth to reduce the reliance on debt. Here are five ways to improve the efficiency of your Balance Sheet.

Firstly, speed up Debtor collection. Every day that invoices remain outstanding is an additional day that you don’t have access to the cash. By implementing effective procedures to shorten the time it takes your customers to pay, you start getting access to your cash quicker, which will help to drive growth more effectively.

Secondly, speed up Stock rotations, or Work in Progress for service businesses. By turning over Stock more quickly or by getting the jobs done more quickly you can free up cash that gets tied up here.

Thirdly, improve the productivity of Fixed Assets. Consider things like how you utilise the space in your premises. Is there an opportunity to generate greater return from currently under-utilised space or plant and equipment? Is your plant and equipment getting the job done efficiently? Are your people trained and motivated to get the best out of the equipment? Are your people sitting in the office, or actively out doing work for clients and billing them for it?

There is so much scope for productivity improvement when you focus on it.

Fourthly, sell unproductive Assets. These are either old Assets that aren’t used any more, which can be turned into additional cash. Or they are Assets that are in use, but which are underperforming. If they are underperforming, they may be costing you more money than they are worth!

As a fifth lever, you could choose to curtail expansion. In that final question we asked ourselves, “Do I like the picture that I am painting?”, if you don’t then you can choose not to grow or to grow at a slower pace … one that is not going to decimate your cash flow and your Balance Sheet.

These aren’t the only things that you can do, but they are a great place to start. By implementing these efficiency measures, as well as others that might specifically relate to your business operations, you can potentially both grow, and improve your cash flow at the same time.

So, in this video we firstly looked at thinking about growth strategically and deciding whether you want to grow and how; then we looked at how you can measure the impact of forecast growth on your business; so that you can plan to efficiently manage growth and cash flow to achieve the desired outcome. With careful planning and managing the growth that many business owners are looking for can be achieved successfully and sustainably.

Thank you for watching our video on ‘Managing business growth’. I trust you found the information useful and helpful and I encourage you check out the other financial education resources on the Davidson Institute website to help build your financial confidence. Bye for now.