Congratulations revenue growth as the main measure is slowly been challenged.
We all love growth as an easy measure of success (and failure)
As I always say when you change the way you look at things the things you look at change. (I have needed to use that expression a little more than I possibly would like)
Recognition is now placed not only on growth as the key measure but a combination of revenue growth and EBIT growth as the new strategic measure.
Strategic growth is now measured as the amount of the revenue growth % plus the EBIT or profitability growth %.
Thus, if venture capital (or other forms of investors) place a strategic growth covenant of say 30%. The measure can be met through a combination of both revenue and profitability growth.
It would thus be acceptable, if you grow revenue by 10% and that translates to a 20% growth in profitability. On the extreme it would also be acceptable if you grow revenue by 30% with no profitability growth.
This strategic growth measure is sort of understandable if you think about what outside investors like venture capitalist want. They are in the flipping business, making revenue and or profitability the key drivers.
On that note which business would you prefer (as a business owner or for your client’s business)
The 3 future states represent the different ways that growth could occur within the next 12 months.
The income statement would look like this
All 3 states provide an improvement in the amount of profit. Yet the profit quality is only improved in future state 2. In my opinion this is still the most effective way to grow as it falls in line with our good growth principal. (ability to convert growth into superior profitability as measured by the improved profit per revenue dollar from one period to the next)
Think about people’s behavior and the way that the measurement system can impact this behavior and the ultimate decisions that flow from it.
The good growth discipline forces the focus on above the line improvement thus restricting the inducement for margin destruction.
If the 3 scenarios were delivered by maintaining the same gross profit margins managers would have to adopt the following actions
In future state 1 managers would increase operating costs by $650k to produce the $2m additional revenue. The result is a $50k improvement in profit. Looking at it differently the return on the additional costs is 7.7% ($50k/$650k). Compare this with future state 2 where the return is 40%. ($100k/$250K).
You could argue that this is pure hypothetical (which it is) however don’t these scenarios play out similarly in reality. At the end of the day there is a top line and a bottom line, the path to getting there can be very telling about the culture, behavior and the decision making that exists within the business especially when it comes to smaller business or smaller business units within large organizations.
If you were in the shoes of an owner in a private company who is focused on long term value creation. Which of these scenarios would you rather see your business direction? On the contrary if you were in a venture capital business that had invested in this business which scenario would you be more interested in.
For those that are interested in using financial statements as a strategic weapon to engage and motivate how managers make good decisions and influence organizational behavior please join us in our journey.
In conclusion the strategic growth is an improvement on the standard growth measure at the minimum it recognizes the managerial ability to create and focus on good growth.
The next post will consider the impact of the strategic grow measure on the balance sheet.