Do you have sufficient capital for growth (and what to do if not)
Updated: Mar 11
Growth equals sales and sales require cash, most of the time. Recently we had a case about growing and expanding with one of my manufacturer's clients. The question of how much capital is required to support the growth is lurking on the surface accompanied by the question of what to do if there isn’t sufficient capital to support the growth.
If this question is also of interest to you, then read on. In this blog we are going to demonstrate, through examples:
How to determine if you have sufficient capital for growth?
What to do if not?
You see, every business has its own capital signature. This capital signature determines if you can grow without burning cash. It also determines how much you can grow with the cash and the debt you have available, as you will need to invest in accounts receivable and inventory.
This is the reason why some companies can grow exponentially and others have a growth spurt, then flatten out to allow the cash flow to catch up and build for another growth run.
Once you understand what your capital signature is and what your approach to profitability is, you can determine whether you are burning cash for growth or you have sufficient cash for growth and you can grow exponentially.
You can adapt your growth strategy accordingly, without running into major difficulties, such as starving your business from cash, hindering your growth potential, etc.
How to determine if you have sufficient capital for growth?
In our client’s case, we wanted to determine how fast they could grow. So, we took their financials for the last 12 months and plotted the numbers into our Money for Growth tool (please see below):
For every £100 of sales, their after-tax retained profit is £9.04, at the current level of company performance. £4.90 of this retained profit needs to be invested in the fulfilment of these sales, which means that they are left with a surplus of £4.14 which they can invest in their growth and expansion. The greater this surplus, the more cash they have available to use for their growth.
What else did we discover?
We saw a strong relationship between their retained profit and the working capital, which means that this client generates sufficient profits to cover the requirements for working capital and has leftover to build cash reserves and fund the growth. This client can grow without burning cash.
Also, we noticed that with a working capital of £4.90 for each £100 of sales, this client has a very little real net cost of carrying (in comparison to their retained profit). This means that their suppliers give them good terms and these terms are used to finance part of their cash cycle. When the real net cost of carry is low, why would they ever risk being out of stock? This really helps their strategy decisions!
This £4.90 is also their recurring income for every £100 in sales. Unless they decide to change the terms of trading (terms with their suppliers and customers) this number will remain constant and they can use it to predict their cash from operations. This is very good to know as it saves a lot of time in forecasting and improves accuracy.
We can see that if they choose to accept lower operating profit, say at 7%, because they are growing, all other things being equal, they will limit their growth potential. They will essentially break-even for cash for growth. In this case, they can either use lines of credit for their growth or wait and accumulate cash and then grow.
You see, a lot of executives fear that they might not have sufficient cash to grow. So, instead of trying to understand their business model and what it can or cannot do, they try to secure external capital for growth.
Executives waste considerable resources trying to secure debt or external capital, without checking first if their business can grow without burning cash.
The numbers tell you a lot. If you can just take the time to truly understand what’s going on in your business, you will minimise the mistakes you make and reduce the losses you incur with your decisions.
What are your options if your growth is burning cash?
If your retained profit (to revenue) number is lower than your working capital (to revenue) number, you will burn cash to grow, because you will need to invest in your accounts receivable and inventory.
If you are in such a situation, you can use 2 strategies to grow:
you can either start using your cash reserves and debt resources, or
wait for your cash flow to catch up and you let it build-up for the next growth run.
You might have noticed that some businesses can grow in a linear way and some cannot have linear growth. Why? Because their growth is burning cash, so the only way they can grow is through a growth spurt, flatten out to allow cash flow to catch up and then have a growth spurt again.
Alternatively, you can make adjustments to your approach to profit and capital. You can either find ways to boost your profitability or reduce the requirements for working capital. This will ensure that your retained profit (to revenue) is greater than your working capital (to revenue). In some cases, this could be the best decision you will ever make as it will solve most of your cash flow problems you encounter during growth.
How about external capital?
A lot of businesses are attracted to the idea of seeking external capital for growth. They think this will solve all their cash flow needs for growth. But, is it?
The issue is that private equity firms are not really interested unless they can use large amounts of investments with very predictable returns. At first, investors get curious and attracted about the prospect of investing. They like the idea and they like what the business does. But… but when they see that the company is burning cash to grow, they become very nervous and reluctant to invest.
If your business has recurring income from a strong contract, then you can use that “asset” to attract private investors. This proposition is attractive to investors because they can turn this recurring revenue into a fixed yield on it.
Outside investors can also be interested in funding operating losses you incur before a business activity becomes profitable (during the growth phase). They like to help you shift the level of sales by investing to keep the momentum going, instead of spending their money on catalytic activities.
If an investor is going to take risks, it better has big returns, or at least your story needs to sell that idea!
Please share, tweet or recommend to those you feel might find this of interest.