How much and what type of finance a business needs to survive is unquestionably one of the most important aspects of management when it comes to running a business. It is also the least understood.
As a business grows it requires more resources unless, of course, it grows by means of a more effective allocation of its existing resources. However, even if this is the case, further growth will ultimately require more resources.
The money used to finance a business comes from two sources, generally referred to as equity and debt. Equity is the capital injected into the business by its owners and consists not only of the initial and any subsequent capital invested, but also retained profits—that is, profits earned by the business and reinvested in it, rather than being withdrawn.
Debt capital refers to borrowings made by the business and includes not only long- and short-term cash loans obtained from banks or finance companies, but also short term credit provided by suppliers of goods and services to the business. Debt also includes finance provided by the way of leases or hire purchase to acquire plant and equipment.
While it is possible for a business to be financed totally by means of debt, this is an extremely risky structure. Unless the business enjoys very high margins and has excellent cash flow, any decline in sales could mean an inability to service the debt and therefore, the end of the business. At the other extreme, a business could be financed totally by equity. While this eliminates financial risk, it also reduces the return that the owners of the business receive from their investment.
While we have established that as a business grows, it needs more resources and therefore, more capital. It is important to understand that the availability of capital for any business is limited, and it therefore follows that the growth rate a business can sustain and still survive is also limited. In other words, a business that grows too quickly will fail, and a business that grows too slowly will deny its owners of potential returns.
When it comes to business growth the fundamental issues which determine how quickly a business can grow are:
The willingness of the owners of the business to reinvest after tax profit to finance the additional resources
The availability of debt finance, which depends on the capacity of the business to service the debt, and the security that can be offered to lenders
Many small to medium sized business owners often believe that banks have an obligation to lend them unlimited amounts of money simply because they have excellent profit potential. However banks are often reluctant to make unlimited funds available and in some cases, this is actually a blessing in disguise. Unfortunately, this reluctance can also mean that some extremely well-managed businesses, which have excellent potential, are denied access to much needed funds.
It is also important to understand that the majority of businesses that experience rapid growth can find themselves confronted by a cash crisis. It is essential when you are planning a high growth strategy to ensure you have control over your finances including receivables, stock, work in progress and margins. Additionally, you should give careful consideration to monitoring your cash requirements, and take action to restrain your growth rate the moment you see signs that your cash flow is tightening. In order to determine how fast you can grow your business, you need to look at your projected cash flow. You can only grow your business as fast as your cash flow allows. Once a business has reached a level of sales where good profits are being made and its rate of growth slows down, then comes the time to harvest the cash flow.