Know When You’re Growing Too Fast or Too Slow
Originally published: 08.01.15 by Ruth King
Business profitability doesn't mean business survival. By running out of cash and not having the ability to borrow or get it in an equity investment, you can be profitable and go out of business by growing too fast.
There are some who say you don't have to grow. I disagree. You must at least grow by the rate of inflation each year or you will start down the death spiral.
Costs increase every year. Whether it is direct cost or overhead costs such as insurance, you must raise pricing to cover these additional costs. If you don't, then your company will become unprofitable. Yeas of unprofitability lead to business death.
Here's the formula, for our industry, that tells you that you are growing too fast:
Annualized sales divided by net working capital is greater than 10.
Annualized sales is your total sales for the year, if you're calculating this ratio at the end of your fiscal year. If you're calculating this ratio on August 31 and your fiscal year end is December 31, then take year-to-date sales through August multiplied by 12, and divide by 8 (the 8th month of your fiscal year) to annualize your company sales.
Working capital is current assets minus current liabilities. These figures are shown on your balance sheet.
Be careful. Your current assets and current liabilities must be accurate!
Current assets are all assets that are cash, or turned into cash, within a year. Generally this is cash, accounts receivable and prepaid expenses. Current assets should not include accounts receivable that are uncollectable or receivables from owners unless owners plan to repay the receivables within a year.
Current assets must include an accurate inventory. If you aren't tracking inventory, or have a lot of obsolete inventory, this value will be inaccurate.
Current liabilities should include the current portion of long-term debt (that portion of a bank note that is due within a year). It should also include deferred income (maintenance agreement work that has been paid for but not yet performed).
If there are payables to owners, they should not be included unless they will be paid to the owners within one year.
Assuming your working capital is accurate, if your number is more than 10, you don't have enough cash to meet your growth needs. Here are three things to do:
- Make sure you have cash reserves of at least three months of operating expenses.
- Grow your maintenance agreement base quickly. This is continuous cash coming in the door. Save your maintenance agreement cash in a separate savings account. You will probably need it to cover growth during slower months.
- Make sure your pricing is correct. If you're pricing incorrectly and at a loss, this is the fastest way to go out of business.
Lines of credit and equity investments in your business can also help. In this growth mode, however, you're probably too busy to focus on getting additional capital into your company.
It's okay to grow. Unless you have huge cash reserves, try to slow growth to 10 or less as you monitor cash. When you slow growth to this level, your office employees will probably make less mistakes, you'll have less callbacks and warranty calls because field personnel aren't rushing to keep up with the work and you probably won't hear "I don't have time to do that."
If your number is negative, your business is probably in trouble.
You have more bills to pay than you have assets coming in to pay them. Normally, this is a pricing issue. You're pricing your new construction, service and replacements too low. Or there are significant warranty issues where you have a lot of expense and no revenue. Determine what is wrong, get some help and fix the issue before your business dies.
If your number is less than 10, you're probably okay. You have enough cash to meet your growth needs, but you should still watch cash flow and profitability.
Ruth King is president of HVAC Channel TV and holds a Class II (unrestricted) contractors license in Georgia. She has more than 25 years of experience in the HVACR industry, working with contractors, distributors and manufacturers to help grow their companies and make them profitable. Contact her at firstname.lastname@example.org or call 770-729-0258.