How you manage your growth is a vital ingredient to your company’s future success. A balance needs to be struck between keeping the engine going and too much growth; and yes, there is such a thing as too much growth. In this post I’m going to explain three ways to manage your growth from a finance (ratios & metrics) perspective. But with every ratio, there is an underlying business function or reason that is causing the positive or negative trend.
From a finance standpoint, a very simple and straightforward equation exists that analysts use to evaluate growth. It involves the Return on Equity (ROE) equation. ROE is net income divided by sales, times sales divided by assets, times assets divided by equity. Another way to put this equation into understandable words is the rate at which your company can grow using ONLY internally generated funds–meaning no additional debt or equity.
This growth issue is more important than many business owners realize, and I have seen several situations in Utah of both healthy and poor growth. I saw as one early-stage company won multiple difficult-to-win contracts and business for that spelled a tremendous amount of growth over the prior year, but they couldn’t internally generate the funds or raise them to fund their operations. They received significant contracts for product manufacturing, but didn’t currently have the capacity to fill all the orders. They had to hire more people and buy additional equipment to meet the demand. To do this, they would need to generate more external funds from investors, but their investors weren’t willing to put up more money since the company had struggled for the last four years on their initial investments. Just as the CEO put together some complicated plans to fund growth, $400,000 of the $600,000 of contracts pulled out. This instantly put the company upside down with a burn rate that caused the company to fold.
There are many ways that growth management can have major consequences–and this example illustrates an interesting point about diversification and growth. Growth is more meaningful when it comes from the orders and business of MANY customers, and not just one or two. In this example, the lack of diversification, combined with the inability to fund the growth in a timely manner were major catalysts to its demise.
The sustainable growth equation is the key to understanding if you are lagging behind or growing too quickly. The components of the equation are the levers you can pull to manage growth.
- Profit margin, or net income over sales. As we consider the numerator and denominator of this equation, a few things can be done. If your actual growth exceeds sustainable growth, you can do things to increase net income such as cutting costs and managing operations better. Anything that will increase net income to sales will improve this. In the case that you are experiencing too much growth, you can always raise your prices and either sales will slow or your profits will rise.
- Efficiency, or sales over assets. This ratio shows how much in assets it requires to make a dollar in sales. The more efficiently you can use your assets, the faster you can grow. Some ways to improve this are to identify assets that you either don’t need or that you can use more efficiently. Ultimately the more revenue you can generate with fewer personnel or equipment, the easier of a time your company will have in growing.
- Leverage, or assets over equity. Leverage refers to how much debt you have taken on. The less equity you need in order to finance assets, the faster you can grow. The danger here is the risk from additional leverage. If you lever up too high, the chance of defaulting on your loans may become higher than the leverage is worth.
I understand that we think about growing too fast from a metrics and ratios perspective, because as CFO’s we see the problems in terms of numbers. But with every number, there is an underlying reason. Our experienced CFO’s can help you analyze your business and discover the reasons why your company may or may not have a difficult time financing its growth.