The value of a company is the result of the earnings and related cash flow that it generates over time. Taking steps to increase earnings and cash flow increases company value. Increasing earnings typically requires making investments before the company realizes the future returns derived by the increased earnings and cash flows on those earnings. Earnings for this purpose are typically referred to as EBITDA which means earnings before interest, taxes, depreciation and amortization. The amount of value that is created by the investments ultimately depends on the investments made and the amount of future cash flows generated, which results in the company’s return on invested capital (ROIC). Therefore, value creation is ultimately driven by a company’s ROIC, revenue growth and the ability to sustain both over time.
In general, high return companies generate increased value through growing revenues, whereas low return companies increase value by increasing their ROIC, which means increasing profitability. Growth strategies based on organic new product or new service development typically have the highest returns as these investments usually require the relatively lowest amount of capital investment. Companies can add new products to existing manufacturing lines and new services can be offered to existing customers.
The companies that create the most value over time are those that grew revenues while maintaining their high ROIC. Low return companies sometimes pursue growth strategies based on the assumption that revenue growth will increase their profit margins and returns reasoning that their growth will increase profits by spreading fixed costs across more revenues. Except for small start-up companies or companies with low capacity utilization, faster growth rarely fixes a company’s ROIC problem. Low returns usually indicate a poor industry structure, a flawed business model or weak execution. Until a company fixes its ROIC problem it should not attempt to grow. Over time, companies that had low growth but increased their ROIC outperformed companies that grew faster and did not improve their ROIC.
Harvest CFO Consulting works with companies to increase their ROIC by increasing earnings and related cash flows. We do this by implementing the financial discipline and the processes and tools to determine where a company’s capital should be deployed to maximize returns, improve sales processes and gross margins on sales, squeeze out costs that do not add value, provide the financial roadmap and ongoing measurements to ensure value is being created and put into place the financial structure necessary to finance growth profitably.