Can You Grow Too Fast? (Part I - Financial Considerations)
Updated: Nov 30, 2020
Is it possible to grow too fast? Maybe this is something you have not given much thought to. All growth is good for a business right? Not necessarily. There are many complications that can arise if your firm grows too rapidly without adequate planning. All growth should be accompanied by a well thought out plan to ensure the company scales effectively and efficiently to support that growth. Furthermore, the company must ensure that the growth aligns with their strategic plan. Growth with deliberate direction and a clear plan is good. Growth for growth's sake, or growing to try to cover currently over-sized expenses is dangerous, and likely to cause more harm than good. There are many pitfalls that can trip businesses experiencing rapid growth. Today we will review some of the financial considerations. Later, we will explore some cultural and structural risks.
While rapid growth will increase sales, it is important to realize that while sales growth increases your top line (and usually your bottom line too) this increased revenue does not always translate into increased cash in the short term. Often, growth will require you to rapidly increase your inventory which is an outlay of cash. This will likely be offset to some extent by the terms of payment your suppliers offer you. If they allow you thirty days to pay, that means you can gain the inventory now, and pay them cash later. Ideally, you will be able to sell this inventory, and receive the cash from the sale, all before the payment terms are due. That would be ideal, but even if you are able to sell all the inventory before the payment terms, you may not necessarily receive the cash from those sales immediately. Depending on your industry, you may also have to offer payment terms to your customers, which increases your accounts receivable, but not your cash. The net result of these factors, is that while sales are increasing, your cash balance could actually be decreasing.
If this is confusing, let's consider an example. Let's say you sell widgets wholesale to various retailers in your region. Your gross margin is 30% and you make 8% profit. Your supplier gives you 30 days to pay, and you allow your customers 30 days to pay, the industry standard for your widget industry. Let's also assume your inventory turnover is 5 times per year. You embark on an aggressive campaign to expand your sales into a new region.
Assuming your balance sheet ratios remain unchanged, this will result in the following changes to cash flow per dollar of additional sales:
An increase in net income, which gains $0.08 additional cash flows
An increase in accounts payable, which gains $0.06 in cash
An increase in average inventory, which costs $0.14 in cash
An increase in average accounts receivables, which costs $0.08 in cash
The net affect of all this is you actually decrease your cash balance by 8 cents for each dollar in sales you increase in the short term. If you successfully increased sales by $100,000 in the new region the first year, you would experience a reduction of $8,000 of cash compared to your normal operations. The reduction per dollar of sales gets worse if you let your collections on accounts receivable slip because you are busy pouring your efforts into growing sales, or if you have to provide commission or discounts to achieve the additional sales, which reduces your margin and profit.
The reduction in cash is the result of the increase in non-cash net working capital. The accounts payable, accounts receivable, and inventory balances have to adjust for the new level of sales. If the new level of sales is sustained in future years, the net cash flow will be the full $0.08 per dollar of sales, assuming no changes in working capital. If the company is able to find a way to decrease the average collection time, extend the average time to pay it's suppliers, or reduce it's average inventory, it would be able to gain additional cash. Please refer to our article on the importance of working capital management for more details regarding this. Failing to account for investments in working capital can lead to cash flow problems and company can actually grow itself into bankruptcy.
This dynamic is only one aspect to consider. On top of that are all of the other needs for cash that a growing business experiences. A company may need to invest in larger office space, more capacity for manufacturing or more floor space, better software, investments in marketing campaigns, hiring more staff, etc. These require an outlay of cash now, in hopes of increased cash flows later.
It is essential that you fully understand the dynamics of your business and have a firm grasp of how cash moves through your business before you launch a major effort to rapidly grow. You will need to create cash flow forecasts to fully understand the demands for cash as your sales increase to avoid running out of cash.