Funding Growth

Unplanned growth can be devastating to a business.  When I was a commercial banker back in the Dark Ages, that was a legitimate concern in lending money to a business.  For most entrepreneurs, unexpected growth sounds like manna from heaven.  Who wouldn’t want that?!

The reality is that unplanned growth can literally bankrupt a company, but many entrepreneurs don’t count the cost of growth.  Let’s break this down into two issues.  The first, is the capital to grow, and the second is structure for growth.

Capital for Growth

Capital for growth is the primary issue facing most businesses, and there are two components.  The first is what does adding a new customer/client do to your cash flow, and the second is how much does it cost to acquire a new customer/client.  

To address the first, you need to have a clear understanding of your cash conversion cycle.  For many businesses, this is fairly simple.  For instance, if you’re a “service business” and you are paid at the time services are rendered, your cash conversion cycle is zero.  That doesn’t mean you don’t have capital issues to grow, but more on that later.

Now consider if you allow people to pay you over time, in other words you carry accounts receivable.  That means you don’t receive payment for an additional amount of time, say 30 days.  Inventory?  Another addition to your cash flow cycle.  To compute your cash conversions cycle, you add your average number of days to actually get paid.  For businesses with accounts receivable, it’s probably somewhere around 30 days.  For those with inventory, it may be an additional 60 to 90 days.  That means to grow, you have to have additional capital to pay for it.

An easy way to compute this for your business is to sit down with your accountant and look at your balance sheet and income statement.   I’ve stolen this concept from Greg Crabtree, author of Simple Numbers.  He calls it the Cash Power Ratio, and is brilliantly simple.  First, compute your working capital balances (e.g. accounts receivable) as a percentage of revenue.  Then compare the total of those numbers to your gross margin.  

If your gross margin is higher than your working capital number, then you can grow cash free.  If your working capital percentage is higher than your gross margin, then you are going to need cash to grow.

One final element on this conversation is the cost of acquisition of a new client/customer.  How much does it take in marketing/sales dollars to bring in a new customer/client?  This must be added into your working capital number and your Cash Power Ratio, because you generally have to spend that money up front.

Comprehensive Example

Gross Margin: 35%

Accounts Receivable: $200,000

Average New Customer Revenue: $10k per year

Revenue (annual): $1MM

Cost of Acquisition: $5k

Cash Power Ratio: Accounts Receivable 20% ($200,000 divided by $1,000000) plus 50% ($5,000 divided by $10,000) cost of acquisition means that you will need cash to grow.  

You sell a new client that generates $10,000 in annual revenue, but you only get $8,000 the first year because you extend them credit.  You make $3,500 on it after direct costs, so less the $2,000 in account receivable, you end up with $1,500 in “free” cash flow, which doesn’t cover the $5,000 you have to spend to acquire the customer.

Structure for Growth

The second component of capital for growth is the overall structure of the business.  You can only grow so far in your current configuration.  After that there will have to be structural changes, such as a new piece of equipment, more space, and/or more people.  Often times this doesn’t line up smoothly with growth plans.  For instance, you can grow subject to your cash flow conversion cycle up to the point that you need to hire a new person to deliver your service, or a new piece of equipment to handle capacity.  That usually means laying out cash ahead of growth.

You have to plan for those expenditures to continue to grow, and the investment may cut into your current profitability.  Your plan should focus on maximizing your growth UP TO the point that you have to make structural changes.  Then have a true cost of that investment, and the timeline to recoup that investment. 

If you care to discuss more please schedule a call today. Core Group is here to help.

Christian Brim