How quickly can your business grow?
When you want to grow your business, you need cash to do so. You may need cash to buy inventory that you can sell to your customers, you may need to pay people to develop the software you sell, you may need cash to spend on marketing to acquire customers, etc. So, not surprisingly, cash is oftentimes the limiting factor when you are trying to grow your business. If you are not willing to (or simply don't want to) use outside capital (debt, venture capital, etc.), your growth will be limited by the amount of cash you need to grow. This article will help you understand how quickly you can grow without employing outside capital. Luckily, it's not too difficult to understand; you just need to know these three factors:
- How much cash do you need to finance cost of goods sold?
- How much cash do you need to finance operating expenses?
- How much do you earn from every $1 in revenue?
Financing cost of goods sold
Most businesses have "cost of goods sold." These are the expenses directly associated with revenue. For example, if you are a retailer, the inventory you sell to customers is your cost of goods sold. If you are a consulting firm, the wages you pay your people are your cost of goods sold. When we think about how much cash you need to finance cost of goods sold, we're talking about the cash conversion cycle[1]. The cash conversion cycle can be broken down into:
- How long does it take you to sell your inventory ("Inventory Days").
- How long does it take you to pay your suppliers for the inventory you sell (your "days payable outstanding" or "DPO").
- How long does it take your customers to pay you after they've purchased your product or service?
Obviously not every company has to consider all three factors, but there are very few firms that don't need to consider at least one of these factors. To help us develop an intuition and understanding of how cash gets tied up, we'll use the following model. You can change how long it takes you to sell your inventory, how long your suppliers will let you delay your payment to them, and how long you let your customers take to pay you. What you'll find is that you need to make a bigger investment in COGS when you have lower margins, when your customers take a long time to pay you, when you hold on to inventory longer, etc.
Financing operating expenses ("opex")
In addition to cost of goods sold, you will also need to finance operating expenses. You'll need to pay things like rent, insurance, marketing expenses, etc. that are necessary to run the business. Your revenue will ultimately pay for these expenses (and more), but you need to come up with the cash to finance them while you are waiting for cash from your revenue (i.e., during the operating cash cycle). It's normally safe to assume that these expenses will be incurred ratably during the operating cash cycle, but you may pay these bills faster (e.g., maybe your opex is dominated by marketing that is spent at the beginning of the cycle to generate revenue) or slower (e.g., maybe you have a very quick operating cash cycle and your opex is dominated by payroll that can be paid towards the end of the cycle). Obviously if you pay your opex towards the beginning of the cycle you will have to invest more to finance opex.
Your net profit
Finally, the last factor that will determine how quickly you can grow is your net profit percent. This is fairly intuitive when you think about it:
- You need to invest in cogs and opex to generate revenue.
- You use the money you generate from the business to make those investments.
We know how much we need to invest from the previous two sections. If we know how much money we are left with from each dollar of revenue, we can calculate how quickly we can grow without outside investments: net profit % รท investment (your "simple growth rate"). If this process can be repeated multiple times per year (i.e., your operating cash cycle is less than 365 days), then the annual growth you experience will be higher than the simple growth rate. If your operating cash cycle is longer than 365 days, your annual growth rate will be less than the simple growth rate.
How quickly can you actually grow?
We can put this all together in a simple spreadsheet-like model: