ask SCORE: Profitable Growth, No Firm Should be Without it
No Firm Should be Without it
By Richard Walton
Assistant District Director for SCORE
Monthly Contributing Writer
A business must grow to survive primarily because growth is the only way one's initial investment can be paid back. After all, there are start up costs to any new venture, and the only way they can be repaid is by generating sufficiently high returns to both pay current operating expenses and have enough left over to repay that initial startup capital investment.
That said, we should focus on how to grow a business. It's not what you think it is. Most people think that growth is about rising sales volume. The more sales, the more growth. But if we focus on sales, we miss the point about being able to pay current expenses as well as additional funds to repay startup costs. That can only be done if the business operates at a profit. So what is really needed is profit growth, not sales growth. But even profit is enough by itself. We need to grow in the areas of expertise that enable profitable growth, primarily Quality and Financial Management. Here's why.
Quality is another word for expertise in business management operations. Most people think of quality as being solely in the product. And while Quality in a product is important, it is not the only measure of quality. Here are some others, equally important.
Quality results from attention to process management, such as purchasing, manufacturing finishing and shipping, billing and collections. No business can grow without quality in all of these factors. And what is perhaps most important, Quality in marketing and sales work is vital, such as providing correct information to customers, following up on prospects, maintaining promised delivery schedules, and constantly improving products. Quality is the first area of expertise that enables profitable growth.
Financial Management is the second area of expertise that enables profitable growth. This is accomplished by three powerful tools in the financial management system. They are: breakeven analysis, ratio comparisons, and cash flow control. Breakeven analysis is used to calculate the sales volume at which costs equal revenue for the firm as a whole, but also for each individual product. Thus the profitability of each product can be determined and managed through cost reduction and revenue building activities always with an eye on growing the breakeven sales volume above which the firm operates profitably, and below which it operates at a loss.
Ratio Comparisons are vital in profitable growth in that the ratio of each cost element to sales volume enables the firm to plan and manage its profitability as volume fluctuates up and down. For example, if the cost of production is 70% when sales are $500,000 (or $350,000 in dollar terms), and volume goes up to $1,000,000, the cost of production must be controlled as a part of profitability management. (Remember, sales growth without profit is not acceptable). In dollar terms, production costs cannot exceed $700,000 (70% of sales) if we are to maintain our planned and budgeted profit target. (Note: there are numerous ratios that can be used in the management of profitable growth. Some others are liquidity, debt, and leverage. Each can be and is used to plan for profitable and/or sustainable operations).
Cash Flow Management is the third tool that is used in the planning and maintenance of profitable growth. Even if operations are profitable as per both BEA and Ratio Comparisons, it is possible that an unforeseen growth in inventory or a slowdown in the collection of accounts receivable can mean that there is insufficient cash on hand to manage operations. This situation can occur quickly and without warning, and unless the firm is closely managing its growth, a cash shortage can appear and undercut the profitable growth of the firm. We manage Cash Flow by carefully planning the necessary payments with the required level of cash, and when it is evident that the firm is vulnerable to a cash shortfall, emergency measures are taken in advance to make certain adequate reserves are available.
Making certain that Growth is profitable requires the firm to emphasize Quality and Financial Management control in all phases of operations. Whether the focus is on product or process, Quality must be the watchword for everything the firm does. In addition, as revenues grow, the firm must maintain the alignment of costs, revenues, and volume in order to grow profitably. Finally, it must be able to product, prepare for and manage the potential of an actual cash shortage as revenues grow and with that growth, the potential for an inventory buildup increases and a slowdown in collections may also take place. Above all else, the concentration must not be upon sales growth alone, but rather a simultaneous focus on sales growth and Quality and cost/liquidity control.
For further information on how your firm can make use of these ideas in your business, contact SCORE.
Mr. Walton teaches Financial Management, Operations Management, Corporation Finance, and Entrepreneurial Finance at Frostburg State University. He is also Assistant District Director for SCORE, Western Maryland, and the President of ERMACORP, a Hagerstown based Management Consulting Firm. He may be reached at 301-462-9850, or by email to Richard@ermacorp.com.