For businesses of all sizes, the credit and banking industry issues of the last decade have raised questions of how to build and sustain organizations with less dependence on external sources of capital (debt and equity) and more from internal resources, such as funds from operations. Organizations are now being challenged to achieve a higher rate of return on the funds they generate from the businesses they are in, such as product and service sales, and from more efficiently run operations and cost management.
As each opportunity is evaluated it is more focused on not whether or not the organization can obtain external funding and just how much that funding is, but on how much return (cash flows and profits) the opportunity (project) will bring to the organization and in what timeframe. For many organizations, the operational questions that arise from this shift reflect less the “market” (Wall Street measures) and more the “customer” (Main Street) perspectives.
Growth Equation Traditionally the growth formula has translated into the following equation:
G = r + (d/e) * (r-i)
G= after tax return on capitalization, r= rate of return on capitalization, d=debt, e=equity, i=interest rate after taxes
In other words, the growth rate is the rate of return on capitalization plus the leverage (debt to equity ratio) times the rate of capitalization less the interest rate after taxes.
However, in an economy in which access to additional debt and equity investment is absent or limited, a company is dependent on its ability to generate revenues and profits that can be held and reinvested into the business, which results in a revised formula of:
G=RP + ((d/e)*(r-i)*p)
(RP=retained profits, p=profits)
As the business is in a steady state of not being able to impact the debt to equity ratio (except to pay down debt), emphasis shifts to improving the profitability of the organization, which can be achieved by:
- Increasing profitable sales
- Managing the costs of operations
- Managing tax liabilities
- Identifying methods of reducing tax rates and liabilities (cross borders and operational units)
- Measuring project/opportunity profitability and costs
As organizations begin to focus on operational effectiveness and grow through an increase in their customer base rather than through acquisition, mergers, or debt/equity financed activities, their internal infrastructure decisions (e.g., staffing, operational structures) will be driven by a need to evaluate on an almost-constant bases. Cash constraints will force evaluations of alternatives on a rate of return basis that includes investment, cash and profit flows, as well as the time to return. Companies must determine if it is better to perform multiple small projects quickly, or a single large project with longer payoffs. The capability of deploying resources and committing them to projects that impact capacity of the organization and utilization of resources will become more critical, as the focus is on growth through the capability of existing resources and the limited ability to obtain new resources as needed.
The New Financing Model
For many organizations, the access to debt has lured them to be less focused on internal funding and making decisions based on operational successes of the organization. Many businesses, small and large, have built organizations that were heavily dependent on their ability to grow at any cost. These businesses were caught “red-handed” and debt-dependent when credit limits and lines were curtailed in 2008 and 2009. As a result, companies downsized or closed because of the heavy dependence on debt for payroll, purchases and infrastructure replacement. For these companies that had been utilizing credit cards and credit lines to make payroll on a monthly basis, the wake-up call was loud, but not necessarily clear as to what changes needed to be made to preserve a core capability that could be funded strictly from profits from the business.
Here’s an example: one service company had been paying its owners and managers six-figure salaries and bonuses every year for more than five years. When the credit crisis occurred, the company was thrown into its own crisis as the business found its credit lines and credit card limits reduced. An analysis of the company’s operations showed that 100% of the annual salary increases and bonuses were being financed by credit. The entire balance of debt was being borrowed and carried month-to-month on moderate to high-rate lending arrangements (interest rates between 14% and 19%). The organization appeared to be in a growth mode as revenues were steadily increasing year over year, BUT the profits were not following. In fact, the profitability of sales was declining AND no one realized that—even before salaries for key personnel were included—the margins on sales were being eroded by discounts, extended credit terms and late-paying customers, not to mention extensive and expensive expense accounts for these same individuals. The bottom-line for this business…it closed.
Growth From Within
Many organizations fail to realize that a slower growth rate from highly profitable customers, accompanied by effective cost management (budgets, strategic plans, marketing strategy and staffing plans) can generate more profits and opportunities for profit than an organization that grows more rapidly with lower returns and less profitability. So just what rate is optimal for growth?
Sustainable growth is a function of the components previously mentioned: rate of return, interest rates, tax rates and leverage (debt and equity). By emphasizing the ability of an organization to reinvest profits into itself, the business focuses on capability to generate additional returns rather than debt and equity servicing (i.e., interest and dividends). As an organization increases its capacity to generate sufficient investment capital, by evaluating each project for context with the organization’s objectives; the impact on revenues, profits, and cash position; and on establishing investment criteria and funds to evaluate each potential customer, project, and opportunity in terms of return and timing of returns, then the organization grows at a rate that it can sustain overtime and through whatever market conditions exist.
Optimal Investment and Uses of Funds
As the source of funds become more operational, an organization must establish processes and evaluation criteria for making decisions on what actions to take, customers to pursue and accept, and how to maintain and even expand capacity. This is the “bottom line” for reaching a sustainable growth rate. For many organizations, the priorities established are dependent upon the industry they are in as well as the cost of both doing business and deciding when, where and how to expand capacity. Investment decisions are trade-offs between human resources (e.g., salaries, wages and benefits), capital investments (e.g., technology, equipment, and facilities), and period costs such as marketing and training.
Successful, sustainable, profitable growth comes from the ability to find the balance between these expenditures and to effectively manage, measure and quantify the returns they generate. No two organizations will have identical growth patterns or results. What each organization will find is that through careful management of operations and reinvestment in its business, growth is achievable in any economy and in any market.
© 2010 Lea A. Strickland, F.O.C.U.S. Resource Inc.
All Rights Reserved.