QUESTION: I’ve often heard it said that a company can grow itself into bankruptcy. If growth means more sales and more profit, isn’t that a good thing? How can a company grow itself into bankruptcy?
ANSWER: It’s true. Depending on the economics of a particular business, a company can literally grow itself into bankruptcy.
Unless your business model is completely broken, an increase in sales will generate more profit.
However, it can also require an increase in things such as inventory and accounts receivable that use cash. Growth can actually be cash flow negative in the short term.
Consider the case of a distribution business. It has a gross margin of 25% and makes 5 cents of profit on each incremental dollar of sales.
The company has to maintain inventory to enable timely shipments to its customers. Its inventory turns four times per year. The business offers net 30 day terms.
But the average customer stretches this a bit and pays in 45 days. The distributor has to pay its suppliers in 30 days. As sales grow, inventory and accounts receivable have to increase as well. This uses up cash.
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Accounts payable also will grow offsetting some — but not all — of the growth in accounts receivable.
If the company’s balance sheet ratios remain unchanged, the cash flow implications of a dollar of sales growth in the current year are as follows:
- Profit will increase, providing 5 cents of additional cash.
- Accounts payable will increase. Suppliers are extending the company credit, which will provide 6 cents more cash.
- The company will have to increase its inventory, which will cost it 19 cents.
- Accounts receivable will increase which will cost the company 12 cents.
The net of this arithmetic is the counter intuitive result that a dollar of sales growth does not increase cash flow in the first year.
On the contrary, it uses 20 cents of cash. The implication is that a successful push to grow revenue that results in a $1 million sales increase this year would actually cause the company to have $200,000 less cash than if sales had stayed flat. That would force many companies into bankruptcy.
To be sure, the changes in balance sheet accounts – accounts payable, inventory, and accounts receivable – are a one-time event.
Therefore, if the dollar of sales growth is sustained it will result in 5 cents of positive cash flow in each subsequent period.
However, businesses that are in a cash crunch right now may not be able to withstand the initial negative cash flow resulting from the sales growth. A business can literally grow itself into bankruptcy.
This is not hypothetical. Unfortunately, it happens to businesses all too frequently.
Not all businesses use cash as they grow. Some throw off cash immediately.
Consider a consulting firm that has excess capacity. An incremental dollar of revenue will not change costs.
Therefore, the entire dollar will become profit. There is no inventory and no accounts payable. Accounts receivable will go up.
As in the example above, that will cost the consultancy 12 cents. However, the dollar of sales growth still results in 88 cents of positive cash flow.
If your business is in a cash flow crunch, before you launch a major effort to grow revenue, make sure you understand the economics of your business.
Will sales growth result in positive cash flow immediately or will it use cash initially?
Once you understand the economics of your business, you can project how much cash you will need to support the growth.
Doug and Polly White have a large ownership stake in Gather, a company that designs, builds and operates collaborative workspaces. Polly’s focus is on human resources, people management and human systems. Doug’s areas of expertise are business strategy, operations and finance.