Growth is Not Optional - It is Compulsory!
A lot of business owners, especially SME’s often say they aren’t interested in becoming a corporate giant, becoming the leader in the market place or being so large they are consumed by their business. And yet when they look at the time they spend in the business, and the returns they get, the effort hardly seems worth it. Growth for its own sake is not always a good thing – and you don’t need to be a listed $500 million company to be seen as successful. But a good return is important and each year those goal posts seem to move.
Cost increases, decreases in market share and red tape and bureaucracy seem to take over your life as a manager and business owner. Before long you are striving for more revenue, more cash in the bank and less time at the office. A business needs to keep pace with reality and with changing market conditions, in order to be profitable. And that means some growth in the key areas of a business is not just optional – it is compulsory to stay ahead.
So what growth should a business aim for? Should the growth focus on revenue, profits, returns or all three?
Inflation & Economic Growth
Increasing revenue comes from increased prices or increased volume – that’s the easy bit. At a national level inflation is currently running at 2.5 – 3.0%, so any price increases less than this is pointless. It will simply be absorbed by your own cost increases.
Growth in the economy is currently at approximately 3.3%, which when compared with inflation indicates that the volume of consumption on average is increasing by at least 1% pa. Once the impacts of exchange rates and export trading terms are allowed for, our economy is showing growth of over 5%. So if any of your markets are shrinking, or growing less than 3-5% then it is time to review your offering and your customers needs and find better ways of selling your products and services.
These figures suggest that a minimum revenue growth requirement to maintain profitability and cash flow levels is at least 5% pa. You also need to allow for any increases in competition and reduction in market share. This simply increases the growth on the remaining products and services even further.
Often businesses have an unwritten (or sometimes written) goal of doubling sales levels over a 3 or 5-year period. It is worth thinking carefully what this means in implementation. A quick look at the chart shows that to double sales over 5 years requires compounding year-on-year growth rates of at least 15%. Not an easy thing to achieve.
Often competitors have the same idea, or technology is changing market demand, regulation is making life harder or you’re in a mature market. Even maintaining 15% year on year growth over a 5-year period is a tough ask, but that is another article.
Realistic goals in the face of current economic growth facts and figures are an important part of the goal-setting process. If doubling sales is critical to your business it suggests that some strategic expansion decisions must be made, and checked against the expected returns on investment required to achieve these. Buying your competitor, investing in new products, revamping your marketing strategy can all produce the strategic growth you look for. But be careful expecting this type of growth if you are really just continuing to do what you have always done. Remember the definition of insanity is expecting a different result from doing the same thing you have always done!
Time Value Of Money
Another reason for planning growth into the business is simply the passage of time that erodes the “value” money. “Today’s dollars” refers to the concept that a dollar today is worth more than a dollar five years from now. Factors such as inflation, opportunity cost, and uncertainty all contribute to a dollar tomorrow being worth less than a dollar today. We all invest money to gain a return of some sort, so as time passes we expect the value of money held now to increase. So getting money now is better than the same money in the future.
For this reason growth is important in any business to at least maintain the status quo. Some growth is required just to stand still and maintain the value of the business. At a cost of capital of 15%, $1 earned in 3 years time is worth only 66% of its value now. So future cash flows need to increase sufficiently enough to add to the value of the business.
This is highlighted in the adjacent chart, which shows the present value of money at a 15% cost of capital growing at 33% pa. It still takes five years to double the value of the cash flow.
But growth in revenue is not the only determining factor of success. You are in business to gain a return on your investment, so the profits left over is really the final goal. Whether these are returned to the business or paid to the owners, the future growth of earnings must also keep pace with other returns available from other investments. Your business must be competitive with other types of investments, else little value is being added to the owner’s pockets.
The time value of money emphasises another impact on the value of your business – that future cash flows can have less impact on current business value than current cash flows. In other words, future cash flows are more risky than current cash flows. This becomes very important when determining the value of your business. It means that future growth must be more than the current economic growth rate to sustain a growth in business value.
Revenue & Earnings Growth
In the recently published BRW Top 1000 (10 Nov 2005) aggregate revenue growth was 7.9%, whilst aggregate profit growth was a staggering 36.3%. And this came on the back of very strong growth the previous year, and many negative economic factors in the past 12 months. This is the impact of leverage – relatively modest revenue growth can fuel strong profit surges, on the back of strong management, a focus on efficiency and well developed marketing strategies.
This leverage is demonstrated clearly by comparing the percentage increase in net profits when you increase revenue and reduce costs. The chart below compares the change in net profits when sales are increased, costs are decreased or both. The blue bars represent 40% cost of goods sold (COGS) whilst the red bars represent 60% COGS.
This shows that profits double by increasing sales and reducing COGS. In fact at a 40% COGS level, increasing sales is more effective than just reducing costs.
The message in this chart is that consolidation and cost savings on their own are not enough. Business improvement must be holistic, targeting the whole business not just costs.
It is true that after a merger or acquisition, the focus should be on capturing cost synergies. Consolidation is a valid strategy in many situations, but the cost reductions should go hand in hand with a critical look at the profitability of your customer offerings. This is what leverage is, finding ways to make the most of cost reduction in conjunction with targeting key markets with your most profitable products. This highlights the need for a planned approach to growth to get the leverage factor right. Market expansion or differentiation strategies must be matched with the correct cost management focus.
Value Adding Owners
We have established that growth is important to maintain performance and earnings growth comes from a holistic approach to revenue growth and cost reduction. But what is the ultimate purpose for this growth? It comes back to the reason you are in business – to add value as an owner to your investment. You investment is measured by return on owner’s equity or ROE. Equity is the investment the owner puts into the business. Profits add to equity, losses reduce your equity. ROE is net profit expressed as a fraction of equity. Growth in the value being added to the owner’s equity requires growth in profits.
The value of any business is the net present value of future after-tax cash flows. So the growth of future profits is critical in increasing the current value of the business. Put simply, future profits increase future equity and hence increase the value of the business.
But there is another reason earnings growth is critical to increasing the value added to the business – profits re-invested back into the business provides leverage in balancing the mix of equity and debt in funding assets.
Equity is the difference between the assets of the business and its liabilities. So the more debt that is used in the business, the less equity the owners have. This is how the use of debt can provide an attractive business return, as long as it doesn’t create too much risk in repaying the debts.
Increasing profits will increase the ROE, as long as the level of equity is not increased. Adding value to the owners is about increasing this return on equity. In general this can be achieved by increasing profits. Ensuring the business assets are used effectively and the business has the right mix of debt and equity financing also ensures the return on equity is maximised.
Where Should Growth Be Focused?
Growth is ultimately required to increase the value of the business, but the focus of this growth in value will depend on the nature of the business. Businesses with a high gross margin and a low break-even level will show the most value added to the business by a focus on revenue growth, whilst maintaining cost margins and asset values at constant levels. Most manufacturing businesses operate on low net profit margins and high asset value, which means that a holistic focus on sales growth with effective asset utilisation is critical in adding value. No two businesses are the same and so the methods for growing the value of the business will be different.
This difference between businesses is why it is critical to conduct a strategic review of business before developing growth strategies. Business plans and strategies must be based on real information about the business, to highlight what constrains current growth and what impacts different strategies will have on the value of the business.
Organic growth for a business refers to gaining increased market share within the current markets. Ideally most businesses need to target a minimum of 5% sales growth in this situation. Earnings growth is boosted by also focusing on cost reduction.
Strategic growth is usually associated with investment that gives more than just organic growth of 5%. Mergers and acquisitions provide one means of adding strategic value to the business. Although even large billion dollar companies such as Coles Myer Ltd and Woolworths Ltd still compare growth by looking at a “same store comparison” between different years.
The message here is very clear – understand the growth of your underlying business – even if you are following a merger path in adding value to the business.
Growth is not just about high sales growth, lots of employees and a large business. It is about maximising the value of the business through a balance in sales growth, earnings growth and the right levels of equity.
This balance must be achieved through understanding key factors such as:
Answers to these questions help formulate a sustainable growth strategy for the business that is based on achievable outcomes. Don’t just accept that growth means more sales – it ultimately means an increased business value. How this is achieved is the start of a journey.
- How the industry and markets are changing and what your competitors are doing?
- How does sales growth affect the profits of the business?
- What impact does reduction in costs have on profits?
- How can better utilisation of assets and debt financing impact the value of the business?
What would it mean to your business to increase cash flow, improve productivity and implement growth strategies?
Maxell Consulting has helped many businesses identify the value in their business and empower the owners to develop plans to crystallise that value.
We offer a free assessment of your situation and review what potential value exists within your business.