Growth is great for a business. Growth creates opportunities for employees, helps companies attract top talent, creates economies of scale, and creates shareholder value. When done successfully, growth just seems to make running the business easier.
The trick is that successful growth is not that easy. You need to have the right structure, capabilities, activities, resources and people in place to successfully deliver on growth in revenue. If you have all of those things in place, then you have to figure out how you are going to pay for growth. Growth can be expensive.
Why is growth expensive when architects and engineers typically don’t require big capital expenditures like production lines or factories in our profession? The biggest reason growth is expensive is that we need to pay for the work to be done (salaries, etc.) before we get paid for the work. We need to fund our accounts receivable and work in process. We also have to have extra cash on hand as operating capital and we may have to make additional purchases such as computers or software to support growth.
The following balance sheet example illustrates why growth must be funded. If this company is anticipating a growth in revenue of 25%, then certain items on the balance sheet will also need to grow simultaneously to support that growth for the reasons stated above.
Projected Balance Sheet
| Current | Forecast Basis | Next Year Forecast | |
| Assets | |||
| Cash | $200,000 | +25% | $250,000 |
| Accounts Receivable | $1,200,000 | +25% | $1,500,000 |
| Work in Process | $200,000 | +25% | $250,000 |
| Property/Equipment | $400,000 | +25% | $500,000 |
| Total Assets | $2,000,000 | $2,500,000 | |
| Liabilities | |||
| Accounts Payable | $200,000 | +25% | $250,000 |
| Accruals | $200,000 | +25% | $250,000 |
| Debt | $600,000 | ? | $600,000? |
| Total Liabilities | $1,000,000 | $1,100,000? | |
| Equity | |||
| Paid in Equity | $200,000 | ? | $200,000? |
| Retained Earnings | $800,000 | ? | $800,000? |
| Total Equity | $1,000,000 | $1,000,000? | |
| Total Liab.+Equity | $2,000,000 | $2,100,000? |
The first thing you will notice is that the balance sheet does not balance! Assets must be equal to liabilities plus equity. The assets necessary to support the 25% growth increased by $500k but the liabilities grew by only $100k as a result of that growth. Another $400k is needed to support this growth and the business needs to plan ahead for this. What are the options for funding this $500k needed for growth?
- The first $100k of capital needed to support growth is provided by growth in accounts payable and accruals that grow as a result of revenue growth. This is great because it is essentially “free financing”.
- The remaining $400k could be funded by increased equity provided in the form of retained earnings. If the company was expensing out profits through bonuses, the bonus pool will likely need to decrease to accommodate this. Taxes can make this option expensive. At a 40% effective tax rate, approximately $670k in pretax earnings (i.e. less bonus in this case) would need to be retained to raise $400k in capital.
- Another way to increased equity is by increasing retained earnings (current year earnings) through increased profit margins. While this may work in the short term, it is likely not a long term solution.
- The remaining $400k could be funded by selling new equity to existing or new shareholders thereby increasing paid in capital. Keep in mind that shareholders require a relatively large return on investment so equity is expensive.
- This could be funded by an increase in debt. Debt is much cheaper than equity but may come with more risk. Funding growth can be great use of a line of credit.
The key to successful growth is that you have to plan to support it – operationally and financially. The keys to planning financially for growth is knowing how much additional capital you will likely need and what your options are for getting it.