Sustainable Revenue Growth
Your business cannot handle revenue growth faster than your resources can support. Think of sustainable revenue growth as the transmission in a car: a car can only reach a certain maximum speed – as well as an effective minimum speed – in any particular gear. Sustainable revenue growth tells us how much additional annual revenue that a business can handle according to the resources in the balance sheet.
Sustainable Revenue Growth Explained
Sustainable revenue growth tells us how high revenues can grow at a set margin. This metric is based on the current gross profit margin, which is generated using the cost of goods and pricing policy. In other words, assuming that labor, materials, and prices stay stable, how much revenue growth can the current business model sustain?
As an example, let’s take a business with stable revenues and a stable net income. This business retains 5% revenue to equity (or net worth) ratio to grow annual revenues at a sustainable 5%. In other words, the business reinvests 5% of revenues back into the business and keeps a steady debt to assets ratio.
If this example business grows revenues by an additional 15% within the next year with no change in gross profit margins (meaning, no change in cost of goods or prices), what is the impact to the balance sheet?
When the revenue increases, the required retention to equity increases by the same amount. The business cannot retain any more than 5% of revenues to equity given its net income margin so the 10% difference has to be made up by either borrowing more or investments from outside shareholders. If the bank won’t lend this money and the shareholders don’t respond, the current liabilities automatically increase. This forces their vendors to finance the growth by getting paid slower.
This situation cannot last forever and results in a business “growing broke.”
If your business continues to grow faster than sustainable revenue, it runs out of the resources needed to finance this growth and all other current operations. Your business consumes balance sheet resources faster than the resources can be replenished. On the other hand, revenue that grows slower than the sustainable revenue limit is not a problem; it builds up reservoirs that, over time, provide more resources for higher sustainable revenue growth.
During the first month of each year, many companies do their financial forecast. The sales force often drives this process. A lot of management time and effort is tied up each year in making this projection, yet a very small number of businesses look at what their sustainable revenue growth has been and what it will be with the new forecast. This can result in revenue growth that cannot be maintained with the resources available so the annual projection is doomed from the start. What the business is doing is forecasting lower cash flows to do more business than the business can sustain according to its balance sheet.
During these projection meetings, the business should calculate the sustainable revenue growth for the year, and then discuss this revenue growth with the sales department. This will assist management to accurately determine what a realistic and financially feasible revenue forecast would be for the next year facilitating higher sustainable cash flow.
Don’t stay in second gear with your foot on the accelerator. Calculating and understanding your sustainable revenue growth is a key to keeping your business on the right track.
Sustainable Revenue Growth Example
You run one of the ~2 million farms in the United States and you grow a handful of staple products: corn, oats, and rice. You have around 200 acres to work with but want to expand your operations.
Your neighbor is selling his 100-acre farm, which is a perfect opportunity for you to make this move. The additional 50% increase in land will equate to a 50% increase in revenue, as price and labor cost projections are stable.
Is this a wise decision?
The first thing to consider is the purchase cost. If you have enough cash on hand (unlikely), you’ll need to determine if this puts you in a dangerous position or not. If it would, then you’ll need to borrow the money from somewhere and pay interest (assuming you’re able).
The additional 100 acres is in the same climate as your so it would require about the same amount of equipment, people, and supplies – seed, water, fertilizer – which equates to a cost of goods increase of around 50%. This leads to an increase in the number of managers and storage facilities needed.
If you’re using sustainable revenue growth to make this decision, then the answer is simple: if you are left with enough money to pay your laborers, maintain your equipment, and not take the financial burden on yourself, then the purchase is likely warranted. If, instead, this purchase will leave you with too much debt, too little cash, or an unacceptable accounts payable time period, then it’s best to pass on this perceived “opportunity” for now.
Grow your business sustainably and don’t outpace your balance sheet. We can show you where your business’s current limits are and make sure that short-term gains don’t destroy long term performance.