In part one of What Every Business Owner Needs To Know About Accounting, we looked at the basic accounting equation — Assets = Liabilities + Equity — and we explained the core behind this equation. (Feel free to review that post for more explanation.) In this post, we’ll addresses the impact of growth on this equation and, more importantly, how it affects your business.
If you were skillful and fortunate enough to grow your sales by 20% last year, your assets probably grew by a similar percentage. That shouldn’t be surprising, your accounts receivable and inventory typically grow at the same pace as your sales. (If these key assets are growing faster than sales, we need to talk.)
Now, if your assets grow by 20%, your liabilities and equity combined will also have to grow by 20%. Here’s why. If your receivables are increasing, it means sales are growing faster than collections. It also means you’ll likely need more computers, operating equipment and vehicles to keep up. So where do you get the money to pay for the growth?
The clients that Kaplan CFO works with are typically in a growth mode. A common question we hear is, “why can’t we just finance our growth from the additional profits we are now generating.”
It’s a great question. In most cases, it’s not as simple as paying for more inventory using newfound sales. Here are a few reasons why:
• Profits may grow at a slower pace than sales if the company is having growing pains or doesn’t manage the growth very efficiently
• The financial statements may indicate that profit is growing at the same pace as sales, but cash is tied up in accounts receivable, so vendors can’t be paid on time
• Profit growth may even be greater than sales growth, but the IRS is going to take as much as 40% of that income in taxes, which is money that could have been plowed back into the business
In most cases, business growth—even if it’s just 10% a year—is funded by debt. The big question is: How much? Now, some business owners are very debt adverse while others wouldn’t think twice about financing 100% of their growth through debt; they represent either end of the debt-equity spectrum. Typically, the best solution for nearly every business lies somewhere in between, where debt and equity are comfortably balanced.
While there are rules of thumb for determining the proper balance between debt and equity, your optimal ratio will differ based on a number of factors. These include the industry, any risk factors and your ability to service the debt. Your banker is usually in a good position to help you decide the proper balance, especially if they will be involved in making the lending decision. Of course, any of the CFOs at Kaplan CFO Solutions are happy to help as well.
The bottom line? Managing growth is challenging. But when done right, with careful planning, it can be very rewarding. Having a trusted partner who’s done it successfully, time after time, helps to. Don’t be afraid to stop and ask for directions as you wade through these challenges. Good luck and get growing.