How To Think About & Model Growth Investments
Our last post “What to Do When Cash Flow Becomes a Growth Bottleneck” generated a significant amount of interest from small to mid-sized businesses who were looking for guidance about how to make sense of growth investments. We introduced the concept of the Self Financeable Growth Rate or SFG Rate created by Neil C. Churchill and John Mullins. While that serves as an important indicator and conversation starter, it’s clearly far from complete. The SFG Rate basically says if we reinvest our cash flow into more of what we are already doing and assume we don’t need to make any big upfront or fixed investments, how fast can we expect to grow?
When we enter the real world however and we need to make investments into new things, that’s where businesses tend to really struggle to confidently make decisions. Unfortunately a lot of these decisions are made more due to “gut feel” than based on data or an overarching growth strategy. It’s grasping that growth mindset which is critical to making sense of growth investments and being able to do so with the conviction that they will compound in the way you want over time.
Applying a growth mindset to your finances means understanding the direct connection between your company’s cash flow and business model and further understanding those things in the context of an overarching growth goal. While that might sound super wonky, it is the only way to truly make informed decisions about where to reinvest cash to fuel growth and what to expect from those investments.
There’s a tool I regularly use for established companies, which actually comes from the startup world, called the Business Model Canvas. It’s a bit of a simplification to say it’s an alternative to a business plan but generally speaking it’s a tool to help visualize the key components of a company’s business model. It’s a worthwhile exercise to walk through and, critically, validate with data from the market. Once you feel you have a validated BMC however, companies should then be able to directly link each BMC component to their financial model.
A personal practice of mine is to construct a company’s forward looking pro forma financial model such that it is a clear reflection of the business model. To put it another way, one should be able to look at a company's financial model and be able to digest most if not all of their business model from it. When I know my business can achieve that, I have an incredibly strong foundation upon which to base our growth strategy. I can understand what areas of the business are going to drive the greatest top and bottom line impacts, with what scale and with what timeline. This will for sure add some complexity to financial modeling. This is not a “assume we’ll grow sales 10% and scale costs proportionately” type of annual budgeting.
If I can validate the business model, then when building a forward looking financial model, I should be able to understand what specific activities I will be undertaking to grow sales. Furthemore, I should be able to understand how effective those activities are, what their timeline is, how much cash outflow is expected for them, how much each sale is worth, and how long it will take for the cash inflow from those sales to occur. I can then literally map those activities and formulate the interdependencies of those variables in my model.
Now as Chuck Stormon, former business partner of mine, used to say “no plan is robust enough to survive a collision with reality.” In other words, the only thing I know for sure about any financial model is that it’s wrong, because it’s impossible to predict the future. But … I at least have a very solid and defensible understanding of my business model, financial model and the direct links between the two. So if I want to start considering where to make growth investments, I am starting from a far more solid foundation to make informed decisions and understand opportunity costs than I would from making solely “gut feel” types of decisions.
