by Richard Harshaw
It is always assumed in business that growth is a good thing. After all, business is like a living creature, right? If it is not growing, it must be decaying!
But does that always necessarily mean that a business must get BIGGER? How about getting BETTER? Is it possible for a business to become smaller (in terms of people) but to generate a lot more profit for the owner (which is the goal of any for-profit business)?
First, consider the complexities that come with business growth. Let’s assume you are a one-person operation. How many lines of communication are there in your business? Just one—you can talk to yourself. (But if you lose your own arguments, maybe you should get out of business!)
Now suppose you add an employee? How many lines of communication are there now? Two. You to the employee and the employee to you.
Add a third person. How many lines? Let’s use letters for the people. You are “A”. The first employee you added is “B”, and the second employee is “C”. Three are three arrows, each with
a double-ended arrowhead. That means there are three channels.
But what happens when we add a fourth person? The channels are not four—they are now 6! And if we go to five people? The channels become 10! In fact, the number of lines of communication grows exponentially according to this rather simple formula:
Lines of communication= (N x (N-1))/2
Here, “N” is the number of people in the company. If you have 12 employees, you have a staggering (12 x 11) / 2 = 66 lines! How many of those lines can you keep tabs on during the day and still get your job done (and keep your sanity?).
Now, besides the complexity of adding lines of communication, consider that you are bringing on board people you may not know very well, each with different ways of seeing life and different norms for behavior. If you aren’t careful, as you grow, your company can get away from you!
That’s the psychological side of things. What about the financial ones, though? One of the greatest tragedies that I see as a consultant is when a contractor calls me in to help and I discover that they are undercapitalized. The odds of survival drop precipitously as capitalization drops below recommended norms. For instance, in general, an owner needs to have about 15% of sales invested in the firm—10% as working capital, and 5% as fixed assets. But if you do slow-paying work (like commercial work on residential new construction) you probably need MORE than 15%, while if you do fast-paying work (like COD service and residential sales with consumer financing), you might squeak by with less than 15%.
I have developed an Excel worksheet that lets you simulate a growth plan and see what it may cost you to grow over the next decade. Then, you can step back and say, “Yeah, I can do that,” or “Holy bat wings! I don’t want to tackle that!” But at least you’ll know before trying to master 190 lines of communication and $3 million in new capital over the next decade.
If you want a copy of this worksheet, drop an email to me (Rharshaw2@cox.net) and ask for the “Long Term Growth Analysis Worksheet”. I’ll send you an Excel file via return email.
I won’t go into the setup of the worksheet, as this will be unique for each dealer. But I will show you a run of the spreadsheet using a hypothetical dealer’s numbers.
This contractor—let’s call him Fester Fonebone—has a 12-person operation that generates $2.1 million in annual sales. He is strongly capitalized and wants to look at a 10-year growth plan. In fact, his capital base is so strong, he could afford to grow about 141% without having to ask the bank for one dime! (Of course, if he uses all his capital reserves to grow that much next year, he must then find capital to grow beyond next year.)
Fester’s staff ratio (ratio of field workers, who bring in revenues, to office workers, who consume revenue) is an anemic 2.0. But his productivity ratio (sales per employee) is stronger than the national average (at $178,000).
The first part of the worksheet shows the growth plan he has modeled. He wants to grow 12% a year in sales. Here is the output of his scenario:
As you can see, his first year of growth will not require any additional investment because he is already strongly capitalized. He is even in good shape for 2020. But starting in 2021, he will need to generate extra capital (in the form of working capital and fixed assets) to support the sales volume he has forecast. In 2021, for instance, he needs to generate $20,702 more in capital than he has now. That is a net profit after tax rate of 0.87%. If he can generate, say, 1% NP after taxes, he can fund his growth internally and not become indebted to the bank. Of course, he can also work a hybrid approach—borrow some from the bank and fund some of his growth internally.
As you can see, Fester would need to generate about $1 million in extra capital over the next decade, averaging about 5% NPAT to fund this growth internally, or splitting the capital needs between retained earnings and bank funding.
If Fester thinks this is too aggressive a plan, he can scale back his growth forecast (using less than 12% annual growth), or even starting off at 12% and dropping it gradually to, say, 8% by 2026.
The other side of the coin—the psychological side, the lines of communication side—is shown by the last part of the worksheet. Here it is:
Fester wants to gradually enrich his staffing ratio to have more “wrench-turning hands” (bringing in revenues) to office heads (which cost money). Ultimately, he should be in the 4 to 5 range, but going from 2 to 5 in a decade is tough. Fester’s plan is conservative—certainly doable—and if anything, may be a bit too cautious. But it is certainly doable.
His growth plan will mean he needs to add 12 mechanics (installers, service techs) and 3 office people to reach his 2.70 staffing ratio goal by 2026. With 12 employees now (and 66 lines of communication), he will go to 27 employees (and 351 lines of communication!). He will have to hire a manager or two along the way to help him carry this growing baby.
But at least by running the Long Term Growth Analysis Worksheet, Fester knows up front what his dream may cost in terms of money and ulcers.
Whether or not he can pull if off is another story.
Next month: the worst case of confusion since camouflage—margin and markup. (Thanks, Larry Phillips, for the idea!)