Determining the ideal balance between profitability, growth and cashflow is as much about achieving the owner’s personal wants and needs as it is the current state of the business and trends across the industry as a whole.
Scenarios exist where seeking to improve each of these three business initiatives makes sense. More than finding the right mix in accordance to a set of “best practices”, the idea should be to analyze appropriate considerations and take a course of action that best suits the owner’s intentions.
Understanding the relationship between profitability, growth and cashflow
Profitability, growth and cashflow work in unison and support each other to maintain an equilibrium in your business. There is no growth without profits, no profits without cashflow and cashflow is heavily influenced by both profit and growth. Each facet of the cycle depends on the others to move forward and how a business owner chooses to act will vary depending on market conditions, personal considerations and business goals.
- Profitability is dictated by the ideal model that a company is after for their products or services and is highly reliant on the industry served. Depending on the industry, specific targets can be set for net profit along with appropriate percentages for labor, materials, software, insurance, and other expenses.
- Growth is dictated by intentional steps to increase investment in people, plant, processes, customers, services, products, etc. An important question to ask when considering a growth strategy is, “Is your industry growing or declining and are you growing or declining with it?”
- Cashflow is dictated by the speed of profitability in conversion to cash, or the number of days it takes between the sale and the delivery of the service to the ultimate collection of the sale and final payment on the payables and payrolls associated.
Potential courses of action in response to a rise or decline in demand
In a steady state, profitability can be very predictable but when demand rises or lowers for your product or service, action must be taken as you think about cycles of profitability, growth and cashflow.
When demand for your products goes up but you are already at production capacity, you can choose to attack the situation in three different ways:
- Growth – if your intention is to grow, you can add people and capacity which could affect profitability in the short term as you monitor sales options
- Profitability – if you decide not to grow, this could be a good time to raise prices to increase profitability to countereffect the demand
- Cashflow – in a period of high demand, you can consider speeding up your cash cycle with deposits up front or adjusting payment terms
On the contrary, when you see a decline in demand for your products:
- Growth – if your intention is to grow and you are well capitalized, one option is to buy similar businesses that are struggling with the decline, alternatively, you could add products or offerings that increase the value of your service, but the costs of these additional services or offerings are typically an investment in R&D and growth and may have a negative impact on profitability
- Profitability – if you decide not to grow, you could consider reducing inputs via labor layoffs and reduce overhead costs to adjust for profitability declines
- Cashflow – to speed up your cash cycle, you could request better terms from your vendors to mitigate the impact of declining sales
Balancing growth with distributions of profit
At Quest, our goal is to help businesses optimize cashflow and profitability while also committing a specific amount of excess cashflow before bonuses and distributions of profit to be invested in the business to support further growth.
A common rule of thumb is to keep 50% of excesses for growth objectives and send 50% home for distribution of profits, but the ideal ratio of growth investment versus profit sharing will depend on what makes the most sense for any given client. We like to look at EBITDA plus owner’s benefits plus any discretionary profit sharing or bonuses first, and then move forward with determining the right percentage to allocate for each goal.