Archive June 24, 2014

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

Execution Risk is one of the lending decision topics that is deeply gray. Bankers have black and white scoring models for leverage ratios, cash flow and other measurable decision components. Properly evaluating the grey area of execution risk is more of an art form than statistical analysis.

Let’s get the jargon out of the way first. Execution risk is the risk that a business will not be successful if they implement their plan, or that they can not successfully pull it off.

Yes, some components of execution risk are embedded in the measurable lending criteria. Perhaps the business is too leveraged, or does not have adequate cash flow. One may look at non-traditional achievements to see part of my point. For instance if someone wants to climb Mt. Everest but does not have the equipment or conditioning, they will likely fail. If someone wants to play sports, but they are not trained in the nuances of the sport, the odds are against the person. The same holds true for businesses. Equipment, preparation, training, facilities and support are all likely components in a successful business plan.

If someone is trying to launch or grow a business without proper equipment or the company is under capitalized, the banker’s decision process is pretty simple. Bankers decline the request and refer the business to a collateral lender, broker, consultant, accountant or investment banker. What if the business seems to have many or most of the core components in place? How does the banker measure planning, conditioning, knowledge, training, and staying power, among others?

To help explain this grey area, I’ve taken eight examples from our five most recent credit applications. I’ve formatted them as rules to assist your loan application presentation.

1. Your materials should be consistent and tell the same story. Inconsistencies communicate that you might not be telling the truth, or that you may fail because of a lack of attention to detail.
2. Speaking of the story, tell one. Explain where you are and how you got there, not just were you are going. The context of the story will make any oddities in your plan make sense.
3. Finalize your plan before you present it. I don’t mean be cocky about it. I just mean that focus and determination can become apparent if you have a finalized plan. Otherwise the banker wonders where you are really going and if you will really get there.
4. Don’t overpay for a business, even if you can afford it. Many entrepreneurs will get overly excited about an opportunity and agree to things that they should not agree to. This communicates that you may make similar mistakes about other decisions in the future. The banker will tend to not trust your judgment.
5. Always have a back up plan. Especially if you are getting approvals from cities, counties or other government entities. Government agencies often take longer to approve something than the typical business owner expects. Planning tells the banker that you have your eyes wide open and are ready to react to surprises. Indeed, Murphy lives.
6. Understand your cash flow and how everything will affect it. You should be the expert on your cash flow, margins, terms, industry preferences, and collections. If you cannot talk fluidly about these items, then the banker will have good cause for concern. They will think … as an analogy … that you are flying a plane blindfolded.
7. Be fully prepared to manage your growth. Too much growth has killed a number of companies, just like insufficient capitalization has. Tell the banker how you will keep from growing too fast. You want to find a way to get the banker to trust your judgment.
8. Take the time to understand how financiers think. Also, know when to approach different types of financiers (banking, collateral lending, and fundraising) because they all have their own niche in financing businesses.

So, if you are guilty of any of these, fix them as soon as you can.

If you need more help, consider hiring a business consultant to assist you. My biggest caution on business consultants is that some of them veer from your real plan, substituting their plan. Do not let this happen. It is good to be trained and coached, and then implement your plan, taking ownership and responsibility for the entire plan.

If you need assistance in finding a good consultant, I am happy to point you in the right direction. Just drop me a line.

Bob Stackhouse, President, Asset Commercial Credit
© Bob Stackhouse – All rights reserved – March 2014

Most people start off their lists of business failure with businesses being undercapitalized. Unfortunately that communicates that money can solve everything. It cannot. It also doesn’t get to the core components that speak to the likelihood of success in bootstrapping the business or the likelihood of obtaining credit or investment. Therefore you will see that my list takes a different look at the problem of success/failure.

I’ve been in the business risk assessment business for over 34 years. I know it well, having financed over 3,000 businesses and managing a portfolio of over a billion dollars of small business loans. Clearly, things go wrong in all businesses. The single most important point is whether or not management has their eyes open, watching risk and has contingency plans. I hope you do not find yourself in the risk categories below:

1. The number one reason businesses fail to thrive is that the principals do not understand the risk of the business and therefore are not watching. Think of a cruise ship sailing without navigation charts … or without someone at the helm. Imbedded in this reason is also the situation where management does not know enough about their business and does not align themselves with people who can help them. This includes engineer business owners who do not know accounting and other knowledge based flaws.

2. The number two reason businesses fail to thrive is lack of focus and clarity of Mission, Vision and Values. Employees can get distracted with their own priorities, likes and dislikes. Whereas clear Mission, Vision and Values combined with laser focus on objectives that are tied to them makes it easy to know where the ship is sailing and how to get it there.

3. The number three reason businesses fail to thrive is that they have either too much structure or too little. Many businesses are started by people who cross over from successful corporate industry. These individuals often implement procedures and processes that worked well in their old jobs. Unfortunately the old job was with a company that might have been mature in their industry, while the new company needs to be entrepreneurial. If they do understand business lifecycles, they might forget to implement structure as they grow. Successful entrepreneurs understand business lifecycles and the need to match structure with their lifecycle stage. This is one of my consulting specialties where I have taught CEOs to be more effective and productive.

4. The fourth reason is that management creates too much capacity in the form of their plant, qualified labor (thought to be irreplaceable) and other fixed overhead. When sales become volatile, the overhead absorbs the profit, and often one of these elements is responsible for a loss or business failure. Outsourcing manufacturing can lessen the risk of this element. Over the last few years, many businesses did not shrink fast enough. Luckily many businesses ultimately did reduce capacity. Shrinkage actually creates cash flow. Unfortunately, when their management wants to grow again, they will find that they do not have the balance sheet support to find the financing that they once had.

5. The fifth most common reason is that they grow too fast and do not have the capital to traverse the growth curve. Basically, they have too much money tied up in inventory and receivables. This is the traditional “undercapitalized” business. Banks allow a certain amount of leverage. If your business outstrips a bank’s pallet for risk, alternative financiers such as Factors or Asset Based Lenders are available to lend to support accounts receivable growth.

6. The sixth reason is they build something that isn’t really wanted in the marketplace, or at least not at the price that it can be profitably delivered. Too many people believe in “build it and they will come”.

7. The seventh reason relates to the long term price support given competitive forces (elasticity of demand). This really breaks down into two things, pricing and competition. We’ll start with competition. Competition includes alternative methods of solving the core issue that are resolved by the product. Too often management ignores the alternatives that our customers have. One must look at all the alternatives when one is evaluating how to price one’s products. Your customers will certainly look at alternatives.

8. The eighth area of general business risk is theft (internal as well as external). Theft and fraud are interesting topics. It is appropriate to design systems and processes to keep honest people honest. Moreover, one must keep an eye on key financial indicators to be alert. It seems that thieves are always coming up with new ways to sneak under the radar. One must keep one’s radar diligent, flexible and current.

9. People management is the next area where productivity is harmed, thereby causing issues with operating margins. The foundation of management is to have clearly understood Mission, Vision and Values. Once established, decisions must remain consistent with this foundation. Follow through, communication, respect and appropriate rewards must be valued by management.

10. The last issue on my top ten list spans both start-ups and traditional businesses. I like to refer to it as Murphy lives! Whenever something can go wrong it will. This especially includes things taking longer than one wants them to, or projects them to take. My best advice is to always have a back up plan and know that things take longer than you want them to.

OK, so there you have it. If you have any of these attributes/issues, give me a call. Once you are aware of the attribute/issue, you may be poised to solve it yourself. You may need the assistance of a Certified Management Consultant that specializes in the area of concern. In any event, subject to availability, I’m happy to have a conversation on your issue, provide you with support including an introduction to a consultant or financier.

Bob Stackhouse, President, Asset Commercial Credit

© Bob Stackhouse – All rights reserved – January 2014