Growth is often viewed as the clearest sign that a business is succeeding. More customers, higher revenue, additional employees and new locations can all be positive developments.
However, growth also creates risk—particularly when it happens faster than the business can financially support.
I have worked for a number of companies that continued borrowing money to fund growth. Borrowing is not necessarily a problem when it forms part of a considered strategy and the business has the capacity to repay it.
The problem arises when borrowing becomes the growth strategy.
Growth costs cash
A growing business will often need to pay for additional employees, equipment, inventory and operating costs before it receives the resulting income.
Customers may take 30, 60 or even 90 days to pay, while wages, suppliers, tax obligations and loan repayments must still be paid on time.
This can create the unusual situation where revenue and reported profit are increasing, but cash is becoming increasingly tight.
Without careful planning, the business may take on more debt simply to meet the cash requirements created by its growth. Each new loan then adds further interest and repayment commitments, placing even more pressure on future cash flow.
Controlled growth
In my experience, many businesses do not need to stop growing—they need to grow in a more controlled and sustainable way.
Controlled growth means understanding the financial and operational effect of an expansion before committing to it. This includes considering:
How much additional working capital will be required
When the new revenue will begin producing cash
Whether the additional sales will deliver an acceptable profit margin
The effect of new loan repayments and interest costs
Whether existing employees and systems can manage the increased workload
What will happen if revenue is lower or slower than expected
Growth should occur in manageable stages, with the results of each stage assessed before the business commits further resources.
Pause, consolidate and strengthen
Growth does not need to be continuous.
After a period of expansion, it can be sensible to pause, allow the business to settle and strengthen the balance sheet before beginning the next stage of growth.
This consolidation period gives the business time to:
Reduce debt
Build cash reserves
Improve systems and processes
Develop its employees
Resolve operational problems
Confirm that the additional revenue is producing sustainable profit and cash flow
A period where revenue levels out is not necessarily a sign that the business has stopped progressing. The business may be creating the financial and operational strength needed to support its next stage of growth.
Preparing for events outside your control
There are many variables in business that owners cannot control.
An economic downturn, the loss of a major customer, an industry slowdown, a natural disaster or an unexpected event such as COVID-19 can cause sales to fall quickly.
Loan repayments, however, generally remain the same.
The downturn that affected the Central Queensland mining industry during the 2010s is a good example. Many businesses expanded during the stronger years by purchasing vehicles, equipment and other assets using debt.
When mining activity slowed and sales declined, these businesses were left with repayments based on their previous level of activity. Some could not reduce their costs quickly enough to meet those repayments and ultimately failed.
The businesses that entered the downturn with lower debt, stronger cash reserves and more flexible cost structures were generally in a better position to survive.
Measuring readiness for further growth
There is no single financial ratio that determines whether a business is ready to begin its next stage of growth.
Debt-to-equity is useful, but it does not show whether the business is generating enough cash to meet its repayments. A broader range of measures should be considered.
Debt-service coverage
Debt-service coverage compares the cash available to meet debt commitments with the principal and interest repayments due during the period.
Before taking on further debt, a business should have a comfortable margin of safety rather than only just being able to meet its repayments.
As a general guide, debt-service coverage of at least 1.5 times provides some protection against an unexpected reduction in cash flow. The appropriate level will depend on the business and the volatility of its industry.
Debt-service coverage is calculated as follows:
DSCR = EBITDA
Annual Principal + Annual Interest
As a guide:
Below 1.0 – insufficient cash to cover debt repayments
1.0 to 1.2 – very tight
1.25 to 1.5 – generally acceptable
above 1.5 – strong buffer
Interest coverage
Interest coverage compares earnings with interest expense.
A business with interest coverage above three or four times is generally better positioned to absorb a fall in earnings or an increase in interest rates than one operating close to its minimum repayment capacity.
The formula for debt coverage is:
EBIT
Interest Expense
As a guide:
below 1.0 – cannot cover interest from operating profit
1.0 to 2.0 – vulnerable
2.0 to 3.0 – reasonable but limited buffer
Above 3.0 – generally acceptable
Some lenders will use EBITDA instead of EBIT, note EBIT is the more conservative formula
Debt relative to earnings
Net debt to EBITDA helps measure the size of the business’s debt compared with the earnings available to support it.
The appropriate level varies between industries. A business operating in a cyclical industry, or one that relies heavily on a small number of customers, should generally maintain a more conservative debt position.
The formula is:
Debt – cash and cash equivalents
EBITDA
As a guide:
Below 1.5 - conservative
1.5 x to 2.5x – generally manageable
2.5x to 3.5x – elevated and needs consistent earnings
Above 3.5x – high-risk especially in a cyclical industry
Liquidity and cash reserves
Current assets, working capital and available cash should also be reviewed.
A profitable business can still experience financial difficulty if it cannot collect its customers’ accounts quickly enough to pay wages, suppliers, taxes and loan repayments.
Maintaining sufficient cash reserves gives the business time to respond when sales fall or customers take longer to pay.
Stress-test the business
Before proceeding with another stage of growth, owners should ask:
If sales fell by 20 to 30 per cent for six months, could the business still meet its wages, tax obligations, supplier payments and loan repayments?
A stress-tested cash-flow forecast can help answer this question.
The forecast should consider what would happen if:
Sales declined
Gross profit margins tightened
Customers took longer to pay
Interest rates increased
A major customer was lost
The expansion took longer than expected to generate revenue
If the business cannot continue meeting its obligations under a reasonable downturn scenario, it may need to reduce debt and strengthen its balance sheet before pursuing further growth.
Revenue growth is not enough
Increasing sales does not automatically improve the financial health of a business.
If additional revenue is generated at a low margin or requires excessive overheads and borrowing, the business may become larger without becoming more profitable.
Management should monitor gross profit, operating expenses, debt levels and cash flow alongside revenue.
The objective should not simply be to grow turnover. It should be to build a stronger, more profitable and more valuable business.
Planning before borrowing
A realistic budget and cash-flow forecast allow business owners to see when funding will be required and whether the expected return justifies the investment.
They also make it possible to consider alternatives to additional borrowing. These may include:
Improving customer payment terms
Negotiating better supplier terms
Reducing unnecessary costs
Reviewing prices and profit margins
Delaying part of the expansion
Funding growth progressively from retained profits
Borrowing should support a sound growth plan. It should not be used repeatedly to cover weaknesses in pricing, profitability or cash-flow management.
Sustainable growth
Successful growth is growth the business can afford, manage and maintain.
A business does not need to move continuously from one expansion to the next. Periods of growth can be followed by periods of consolidation, during which the business reduces debt, builds cash and strengthens its systems.
By understanding the relationship between profit, cash flow and debt, business owners can make better decisions about when to expand, how quickly to proceed and how that growth should be funded.
The aim is not growth at any cost.
It is controlled, profitable and sustainable growth that strengthens the business over the long term.