When most companies think of their growth, they look to the income statement and measure their change in revenues or profits from one year to the next. There are lots of strategy and tactics that go into a company’s growth, but an important first question is: What is our capacity for growth? The answer to this question is actually on your balance sheet.
In private companies, capital allocation and the proper management of the balance sheet are often overlooked. Using an analogy of a car, the balance sheet is the engine that provides a company’s capacity to grow. In that regard, there are only a handful of measures that really matter.
The first is the relationship between the company’s assets and its sales, called Asset Turnover. Asset turnover measures how many dollars of sales are being generated for each dollar of assets invested. For instance, if a company had $10M of sales and $5M of assets, the ratio would be 2:1. On the surface, that number does not mean much unless you can benchmark yourself against your industry. In this example, if the industry standard was 3:1, that tells you that you would be efficient with the use of your assets if you were driving $15M of sales off of your $5M asset investment. The ability to drive more sales capacity is directly correlated to the level of assets you control.
Leverage is another measure that affects a company’s capacity to grow sales. Leverage refers to the blend of liabilities and equity that fund the company’s assets. In this context, leverage measures how many dollars of assets a company controls for each dollar of equity invested. By employing the proper mix of equity and liabilities, a company can maximize its ability to acquire assets which in turn allows it to convert such asset investments to increased sales. Too much leverage is never a good thing and can be reckless. However, too little leverage can be just as bad because it infers that a company may not be getting the most efficient use of its equity.
While neither asset turnover nor leverage get to the heart of the matter of how you grow, they can tell you your potential to grow and whether you are getting the most out of your investments in assets and equity.
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