Knowledge Base

How Fast Can You Grow?

By: Kenneth J. Wasmer

Several years ago the headlines stretched across the business section: "Boeing booming, but profits a bust." The article went on to say "Business is so good at the Boeing Co. that it's losing money. The world's largest manufacturer of commercial jets is so swamped with orders - and is so far behind - that it will cost the company $2.6 billion in the coming year. Late deliveries, a lack of skilled labor, parts shortages and a snarled assembly line have resulted from an unprecedented increase in production."

So, how fast can you grow? In Boeing's case, they are growing too fast! Boeing went from total orders for planes of 120 worth $7.8 billion in 1994 to 355 planes, so far this year, for a total value of over $25 billion; an increase of over 220% in three years. Boeing's multi-billion dollar problems (yes that is billion with a "B") can largely be centered on infrastructure. How do you hire and train 32,000 employees in a year and expect them to perform? Fortunately for Boeing, its capital structure will be able to handle the growth pains. However, few resellers and VAR's have the capital depth of a Boeing. When they go through the same growth problems, albeit on a smaller scale, it normally means they go out of business.

For example, one reseller was awarded a single contract that exceeded all of his prior year's sales. Excited, because his ship had come in, he rushed out and added employees and facilities to fulfill the new contract. Without detailed analysis of the new contract, the owner was confident his core business would be profitable enough to handle the ramp-up expenses for the first six months. After that time he should be sitting very nicely. He re-deployed his staff so that experienced employees were working on the new account (he did not want to take any chances with mistakes). After six months, his performance under the new contract was only marginal due to his staff being stretched too thin training new employees, but the worst part was that his existing business was down almost 50% because no one was paying attention to his "old" customers. Without the "hand-holding" that his customers had become accustomed to, which was the reason the reseller was successful in the first place, the customers left. The hit to profitability was too much to overcome. The reseller was out of business six months later.

We can easily show where this company made mistakes. The staff wasn't deep enough; key employees were taking on more than they could handle and were being asked to perform in areas outside of their expertise. Systems could not handle the growth; the accounting software was designed for a company half the size before the growth. The accounting department just couldn't process the purchase orders, receivings, invoices, payables, cash receipts, etc., fast enough. Facilities were too small; the warehouse could not handle the product being staged for configuration and delivery. Personnel were "sitting" on top of one another, yet trying to move to new facilities took focus away from the customers. Processes and procedures were simply inadequate for the existing company, let alone one twice the size. Although the reseller was convinced he could handle the increased sales volume, his finance company was not. The reseller was always behind the growth curve in obtaining the funding he needed.

So what could the reseller have done? Yes, hindsight is always 20/20, but in this case there was no foresight at all. The reseller simply did not plan. From an infrastructure standpoint the question of how fast you can grow is very subjective. However, from a financial perspective the question of how fast can you grow can be answered with more objectivity. There are two critical elements to growth; cash flow and leverage. Detailed cash flow projections should be prepared. Projections should be done for your worst case, realistic and best case scenarios. It is just as important to be able to handle the cash flow under the worst case as it is the best case. When doing the cash flow projections it is important to distinguish between cash outlays and income versus accrual accounting. If your inventory and receivable days outstanding exceed your payable days outstanding, as is many times the case, your cash flow decreases with increased sales.

This can be highlighted by looking at a simple example. If you sell product for cost plus 10 points and you are borrowing 80% of your receivables, your cash flow will be short 12% of the purchase amount.

Sell product under terms 110,000.00 A/R advance at 80% (needed to pay inventory) 88,000.00 Cost of Inventory 100,000.00 Shortfall ($88k minus $100k) 12,000.00

Cash flow problems are very real in growing companies simply because many companies can not retain profits quickly enough to internally capitalize the growth of the business. The result is increased leverage or increased debt to net worth.

Leverage problems can be calculated using a formula to find the sustainable growth rate. The principal behind the sustainable growth rate is fairly simple. Doubling sales will result in a doubling of your receivables outstanding (if the A/R turns stay constant). Likewise, inventory and most other assets will also double. Therefore, in order to keep the same leverage (debt to net worth ratio) in your business, your equity will need double. In other words, you will have to be profitable and retain the profits in the business at a rate sufficient to build equity at the same rate your assets are increasing. The sustainable growth formula below will allow you to calculate your maximum growth rate, assuming you keep your leverage constant.

ROA x (1-D) = SG E/A - (ROA)(1-D)

ROA = Return on assets which is net income divided by total assets. D = Dividend payout percentage (or bonus payout %). E = Total Equity (stock, paid in capital and retained earnings, or total owner's equity). A = Total assets. SG = Sustainable growth.

Many companies have failed in this industry simply because they grew too fast. Let's take a look at the following hypothetical scenario. A company is producing $2,000,000 in revenue, has inventory days outstanding of 25, receivable days outstanding of 38, and they pay their bills, for the most part, on time. Their bottom-line net income, after owner's bonuses and taxes, is 1.5% of sales and their debt to net worth is a healthy 2 to 1(All of these numbers are typical for many companies in this industry). If we assume that this company doubles its sales each year for the next three years ($2 million to $4 million and then to $8 million) with no changes in asset and liability turns, it will have a cash crisis that could put the company out of business.

Let's analyze this further. The chart below shows that in just two years the company will have a potential cash shortage of almost $88,000. The cash shortage could not be made up through existing asset-based lending facilities because all lines would be maxed out. Naturally, the reseller could simply stretch out vendors to make up the short fall. But with continued growth, the problem could triple in the next year and there is no hope of recovery at that point.

End of End of Restated Beginning Year 1 Year 2 Year 2* Sales $ 2,000,000 $ 4,000,000 $ 8,000,000 $ 8,000,000 Net income $ 30,000 $ 60,000 $ 120,000 $ (15,000) Cash $ 30,583 $ (8,833) $ (87,667) $ (222,667) Accounts receivable 211,111 422,222 844,444 844,444 Inventory 125,000 250,000 500,000 500,000 All other assets 50,417 100,833 201,667 201,667 Total Assets $ 417,111 $ 764,222 $ 1,458,444 $ 1,323,444 Total Debt $ 287,111 $ 574,222 $ 1,148,444 $ 1,148,444 Equity 130,000 190,000 310,000 175,000 Total Debt & Equity $ 417,111 $ 764,222 $ 1,458,444 $ 1,323,444 D/NW 2.21 3.02 3.70 6.56 * Assumes a loss of $15,000 in year 2.

Another very real problem is what happens if "infrastructure" problems (as in Boeing's case) cause the reseller to be marginally profitable or, worse yet, incur a loss? If, for example, the company incurs a $15,000 loss in year two the cash shortage would be almost $223,000, which would exceed the company's total net worth. In order to fund the cash flow (have a positive collected balance in the checking account) the debt to net worth ratio would have to increase to over 8 to 1.

Assuming the company could return to modest profitability the next year, with continued growth the debt to net worth would surpass 11 to 1 and total debt would be close to $3,000,000. The cash flow shortfall would exceed $600,000, more than two times equity. At this point in time there is little hope of survival unless the company re-capitalizes the business by the $600,000 shortfall or makes drastic changes operations and cuts sales levels. The reality is that few companies can recover. What must be emphasized is that this company was profitable in every year except one, and in that year they only lost $15,000.

This company exceeded its sustainable growth rate and, like many others, is in danger of going out of business due to severe cash flow problems. Using the sustainable growth rate formula, this company would have been able to grow 30% in the first year and stay at the same leverage. By calculating the sustainable growth rate at least annually (quarterly or monthly is preferred) and preparing detailed cash flow projections, the company would have realized its growth plans were too optimistic. At that point, the reseller could have set in motion any number of plans which would have allowed for increased growth (i.e.: decrease inventory and receivable days outstanding, bring in additional capital to the business, increase profitability and retain more earnings, etc.). The important point is to understand that growth can be healthy and profitable, but you need to plan for it.

 

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