You may have heard the words sustainable growth and not thought much more about it. You may have even studied about it in college. Unfortunately many business people forget what they learned because they are too busy or distracted with all of the details of their business. After all, sustainable growth is a concept within accounting and accounting is for someone else … isn’t it? … No! No! No!
First, accounting is for every successful business person. Accounting is like a pilot’s instruments when he/she is flying at night in the fog. Accounting is like the marauder’s map in Harry Potter. Harry needs to know when Snape is just around the corner. Accounting is more than your friend, it’s your eyes and ears when you can not be everywhere at the same time.
Next, Sustainable growth is more than a concept or theory. It is a practical method of calculating how fast you can grow naturally without the infusion of cash from an outside source. If you are in business, studying sustainable growth is the key to maximizing your opportunities. Think of it this way … if you find yourself in a maze, you’ll want a map that directs you in the fastest way out of the maze. Sustainable growth is that map.
The way to understand sustainable growth is like building a house. Start with the foundation and then build your home. The foundation is pretty simple. You can only grow as fast as you retain profits. The formal way investment bankers define this to their public companies is: Return on Equity minus dividends. Unfortunately it does get more complicated than that when you look at small businesses. Let’s use an example:
Let’s first look at one business cycle. Say you have 1,000 in cash to start a business. You buy inventory for $700. You pay someone $200 in commission for each sale. And you pay someone $100 per week to handle paperwork and shipping. You sell the goods for $1,200. That returns you your initial $1,000 plus $200 profit after you collect from the buyer. We’ll ignore taxes and many more overhead components to keep the example simple. This is one business cycle. It may take days, weeks, months or years, depending on the product/service & business.
You think to yourself … gee … let’s double things right away because twice as much is a good thing. You tell your sales person, good job. Now, go ahead and sell two. The person jumps right on it and sells two. Now, you have a problem. You only have $1,200. You need $1,400 to buy two products at your cost. Your business either blows up by upsetting your customer, or you ship one and tell the customer they have to wait, or you talk the supplier into trade credit, or you use your credit cards. Oops, then there is payroll. You owe the sales person $400. in commission and the paperwork & shipping person $100. In my scenario, the paperwork person can handle the additional work because it is the same week. You don’t have the money to meet your obligations and are faced with missing a payroll or borrowing money from someone, or like many businesses do, don’t pay your taxes. None of these situations are good for long term success. Too much growth, too fast! Not sustainable. Ouch!
Unlike the out of control growth in the above “doubling immediately” scenario, Sustainable Growth is the amount of growth you can accept within your financing constraints.
You’ve probably figured that after five business cycles, you’ll have your original $1,000 plus $1,000 in profits. At that time you can afford to sell two units. After another three cycles you can afford to sell three units. At some point you’ll reach the capacity of the paperwork person and you’ll need two of them. At some other point, you’ll hit the capacity of the sales person to sell and you’ll need additional sales people. And this is how a business grows naturally, sustainably.
OK, so let’s complicate the equation. Real businesses tend to overlap their business cycles, not complete them end to end. They tend to be always selling, always buying, always servicing, and always collecting. Hopefully they have enough capital to support a given level of sales. Now they want to know if they can grow beyond a particular ceiling or how they can grow at all. So, how fast can they grow?
The foundation continues to be: retained collected profits fuel or make additional cash available to pay for increased cost of goods sold which enables sales to increase. But we cannot stop here in explaining sustainable growth. We need to answer the question, what fuels the creation of cash? The sustainable answer continues to be retained collected profits.
Is there anything other than profits? Yes, it is important to note that there are significant temporary methods of gaining incremental growth. Once these methods are implemented, they hit a ceiling or maximum point of effectiveness for incremental growth. These methods are collecting receivables faster, selling your receivables, stretching out accounts payables, sale of unused assets, shorten the business cycle, make efficiencies in the delivery of products or services (do more with less), and defaulting on debt (employee taxes). OK, so I’ve missed some options that are unique to certain industries, but you get the point.
Some managers have success with these methods but seemingly don’t understand why they hit a growth ceiling. My answer is that you can only collect receivables so fast after which you upset your customers. You can only stretch payables so far and then they put you on COD. You can only push your employees so far until they start to become less efficient. The government will only put up with delinquent taxes for a short while, and then they really get in your way of operating the business. Business efficiency and automation can be continually effective for certain types of businesses, but not all types of businesses.
You may ask the question, what interferes with sustainable growth? The biggest item is the business owner that does not fully understand sustainable growth. Often they will withdraw too much from their companies and/or will create too much capacity, thereby wasting monies that are otherwise needed to grow. Oh, and of course, unprofitable operations, but that is a whole other story.
Basically, once you compress your business by using the temporary other methods and have established a fairly static business model, you can calculate sustainable growth rate, right? Not so fast. We have another thing to look at, “other & non-cash business growth constraints”.
What do I mean by “other & non-cash business growth constraints”? I mean those items that need to expand in stair steps versus proportional growth. If you are selling … say toothpaste, and double sales … the cost of the toothpaste is probably close to twice the original amount (though perhaps not because of discounts). Alternatively, if you are providing a service and the service can be performed by current staff, then the marginal sales are more profitable than the previous ones because you do not have to pay your staff more to accomplish the growth. But what happens when you have to hire a new employee and train them. The hiring process, on-boarding process and training are all costs that do not immediately have a productive affect on sales. Initially, they are detrimental. The same period of less efficiency affects new sales people, new service employees and new mid-managers. Indeed many businesses grow to a point of nice efficiency, then they sacrifice profits as they hire and increase capacity. At some point sales increase and efficiency raises to higher levels. It is at the plateaus that businesses enjoy the most profits.
Another area of “other & non-cash business constraints” happens when you expand territories, come up against new competition and sharpen your pencil to retain sales and customers. Basically … your internal profit engine changes to a new matrix. I cannot emphasize enough the benefit of understanding your accounting and the stories that are told by the numbers.
Speaking of stories told by the numbers, the balance sheet is perhaps more important than the profit and loss statement in telling stories. Hmm. Maybe not, but it is very important nevertheless. One can take two balance sheets and compare them and see what has changed over the time span between the balance sheets. This is an especially good way to see how cash was created and how cash was used. It’s called a source and use of funds. It’s like looking at the land from 1,000 feet in the air. You can see the relationships in a different way than if you were standing on the ground.
Now that you have a handle on sustainable growth, calculate your growth, your income and compare them to your goals. If they fall short, consider selling unproductive assets, selling receivables or incurring some debt to get you where you want to be. Think of these choices as fuel for increasing product or payroll for increasing service income. Remember to calculate the time that your customers will take to pay and the number of business cycles that you want to overlap. After you have done this, include the cost of the funds in your overhead and see if it makes sense to borrow money to grow. Sometimes it makes sense, sometimes you are better off just growing naturally or not at all.
If you have an even more complicated scenario or would like to talk about this more, then give me a call.
Bob Stackhouse, President, Asset Commercial Credit
© Bob Stackhouse – All rights reserved – June 2014