"When will my business become profitable?" It's a question that is all too familiar for business owners, and one that keeps many entrepreneurs up at night.
Once your business starts generating a profit, the focus shifts to increasing those profits. Many falsely believe that profitability can be improved simply by cutting costs or increasing sales. Yet there is so much more to the profitability equation. Another critical component? Return on capital.
Many successful entrepreneurs will tell you that growth requires investment. The reality is that most businesses have limited time and capital to invest, so whatever they have needs to be invested in a way that produces the greatest return. This is measured by assessing a company's return on capital: predicting the return of every dollar invested.
Here's how it works:
1. Determine how much capital is needed. This could be for new equipment, facilities, personnel, technology and working capital.
2. Identify when this new opportunity will start generating revenue, factoring in any related operating costs. Realistic revenue forecasts consider:
- Time needed to develop the new opportunity
- Number of customers secured
- Revenue per customer
- When the revenue will be secured
3. Compare expected profits with the capital investment needed. Calculate the return by dividing the profit by the amount of capital invested. This can be calculated monthly or annually.
By selecting opportunities with a higher and faster return on capital, the business's rate of growth and profitability can be improved.
But not every strategy is right for every business.
Consider the example of a snack food manufacturer. The company sells 70 per cent of its product to one large retailer. It must decide whether to expand production capacity to increase business with this existing customer or invest in developing new customer relationships. The return on the capital employed would likely support growing the business with the existing large retailer.
However, it may be extremely important for the business to develop new customer relationships to reduce the risk of relying on a single customer. The business owner in this situation would need to weigh the strategic considerations and risks to decide where to invest the resources to better position the business for the long-term.
Here's how to determine which growth opportunities are the best fit for your business:
- Assess your business’s needs and resources, then pick the growth opportunity that meets these requirements. Opportunities may exceed available resources, so tough decisions need to be made. The snack food manufacturer’s management may not have time in the current year to expand production capacity for the existing customer and actively develop new customer relationships. A decision would need to be made on which route to take.
- Balance financial returns with the best strategic fit for your business. While strategic fit and risk are key considerations, financial returns assess profitability and capital needs. The snack food manufacturer may be able to expand the plant with available investment dollars and produce swift profits. However, this financial benefit should be weighed against the risk of further relying on one customer and failing to cultivate new ones.
- Examine the business’s financial capacity. Each part of the business will require different growth capital at different times. While additional funding can be sourced with time, the near-term financial capacity to grow the business is often limited to the cash flow generated from the business, bank financing or additional owner investment. Our snack food manufacturer may choose to expand capacity with the existing customer and defer pursuing new customers until the financial capacity of the business improves. Regular cash-flow projections and a good banking relationship can also help create additional financial capacity.
As tempting as it can be to jump on potential opportunities that increase profitability in the short term, it's important to ensure that investments are aligned with the business's needs, resources and business objectives.
Investing in opportunities with the greatest return on capital that also have a strategic fit will not only position a business for financial success, it will help pave the way for future growth and an expanding group of new growth opportunities.
Troy MacDonald is the national corporate finance leader for Grant Thornton LLP. He specializes in advising public and private sector clients on implementing transactions and debt and equity financing solutions in both domestic and international markets.
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