Financial Literacy 104: Want Growth?

Disclaimer: The views expressed here are personal and meant for information/education purposes only and not representative of his employer directly or indirectly. Any mention of company names are for illustrative examples only.

This article is part of a series on Financial & Strategic Value Creation written for Technologists / techies: "Financial & Strategic Value Creation for Techies 101", "Financial & Strategic Value Creation for Techies 102: Analysis & Valuation", "Financial & Strategic Value Creation for Techies 103: Power of Compounding & Discounting", "Financial Literacy 104: Want Growth?", "Financial Literacy 105: Strategy Meets Execution"

PS: Selected older articles (2016-18): Blockchain/Crypto/Digital Tokens, Cashless Finance: UPI, Blockchain/Agri & Supply Chain Finance, Digital Agri: Commodity Spot / Futures Markets, Digital Agri: Future of Insurance, From Barter to Blockchain: Brief Journey of Payments & Ledgers, Cashless Financial Inclusion...

Want to build a growth business? It comes down to three things to focus on BEFORE you grow:

1. Customer Value Proposition that can potentially be scaled efficiently to a large number of customers (i.e. large total addressible market (TAM), and "big problem" worth solving). This is also called "Product Market Fit (PMF)" (ideally scalable and profitable and validated!).
2. Efficiency & Productivity: of all resources (internal & external): capital, labor, customer time, go-to-market (GTM) channels, partnerships to maximize the size of the value pool.
3. Risk Mitigation: of key & tail risks, i.e. contingencies that if go wrong can derail growth. This should ideally be worked out BEFORE scaling up a growth model.

A key tenet of finance is that reward (i.e. return on capital) should be greater than risk (i.e. cost of capital). You need this positive BEFORE you scale up growth, else you will just be scaling up a negative number to a larger negative number, i.e. destroying (shareholder) value. More specifically this (return - risk) or economic spread is in the exponent as we shall see below -- so when the economic spead is negative, it implies exponential declines, and conversely, it can be exponentially growing if large & positive economic spread.

#1 and #2 above focus on returns/rewards and #3 focuses on risk.

If you think harder, the customer value proposition is the efficiency and value of the proposition / offering / product vs substitutes that the customer has, i.e. #1 and #2 are just forms of efficiency & productivity. Think of #1 as "customer productivity" and #2 as "operational" or "capital" or "labor" efficiency/productivity.

#1 Scalable Consumer Surplus: As an example of "customer productivity" any good electric vehicle (EV) vs Internal Combustion Engine (ICE) offers superior conversion of energy input (eg: electrons in or gasoline in / diesel in) to energy output (traction on car wheels and km travelled). In addition a great product (eg: Tesla Model 3, or the original iconic iPhone) offers a lot more capabilities and experiential value not offered in any single alternative substitute package for the price at that point in time.

Value is often in the eyes of beholders, and for them, "you know it when you see it" or as Clayton Christensen articulates, it addresses a "job to be done" for the customer (vs no alternative). Netflix CEO Reed Hastings famously said Netflix's competition is sleep.

The difference between fundamental value experienced by the customer in their heart, minds and gut, and the price they see is their incentive to adopt and advocate for the product / service. The efficiency (relative to alternatives) for the customer, love and advocacy gives you demand-side economies of scale (or increasing returns to scale) and lowers the incremental cost of acquiring, retaining new customers and encourage them to have multiple transactions / subscriptions with your company. Chamath Palihapitiya summarizes it nicely: "Value is what I buy. Valuation is what I pay." Warren Buffett said, "Price is what you pay. Value is what you get". This is as true for customers buying the product/service from the company as it is for investors considering providing capital to the company (eg: buying stock in IPO, pre-IPO or in the secondary markets).

It is important to solve an important problem across multiple customers - so that the aggregate "value pool" (i.e. sum of customer surplus and value captured by the firm) is huge. A subset of the "value pool" is the so called (gross) "profit pool" available in the market you are targeting (as opposed to the total addressible market (TAM) which measures the "revenue pool"). Typically these opportunities lurk where there are significant inefficiencies in a customer/market segment that can be remedied through clever use of technology, and convincing them to adopt (to realize / share value) at scale.

The next important aspect is that this value should be scalable across a market (i.e. a number of customers) that can be economically served via an appropriate "go-to-market" (GTM) approach. For example if you have to heavily market / advertise to acquire the incremental customer and/or your direct sales cost per customer or per transaction is high, it may not be an attractive segment. The trick is to crack both the customer value proposition problem (i.e Product-Market Fit / PMF) and the "go-to-market" (GTM) and unit economics (cost of customer acquisition or transaction vs value of customer (lifetime value) or value of transaction) should make sense; or at least there should be a path to getting it to sensible numbers.

Net net customer value prop, PMF & GTM is a form of efficiency, also called consumer surplus. This creation of a customer and the scaling of customer surplus is perhaps the most important outcome of "innovation". What you need is scalable or recurring consumer surplus.

#2 Growth Flywheel: Efficiency and Productivity: The "flywheel" banner at the top of this article conveys the simple fact: be efficient BEFORE you grow and DURING growth. In lean startup land, this is referred to as getting the "product-market" fit and "value-market" fit right (i.e. both product adoption/experience; and monetization) before scaling. Where it is possible to get organic adoption at low unit costs, it is common and OK to decouple the adoption curve while the monetization curve catches up once the efficient monetization/business model scaling is established.

A financial way of expressing this is: ROCE (return on capital employed) > WACC (weighted average cost of capital). Another view that the "maximum self-sustained potential growth rate (g)" possible without additional infusion of capital is ROCE.

Growth is not an end in itself: only efficient growth creates value; inefficient growth destroys value ... and this creation/destruction dynamic is faster if you grow faster! The mathematical reason for this is that the accumulated capital in the limit is an exponential function with (g - r), which I call "economic spread" in the exponent of the exponential. If g-r is negative, you destroy value exponentially !

And conversely if (g - r) is positive and larger, you self-generate a lot of capital to grow even faster. Investors look for "consistent compounders" i.e. business engines that can deliver large, positive (g - r), and consistent economic spreads over multiple years. As discussed in a prior article - the exponential power of compounding wealth creation plays out over multiple years much more than we tend to linearly imagine. This is the "financial / economic growth flywheel" pictured at the beginning of this article.

Another very important fact to keep in mind in the financial growth flywheel: if your return on capital is g, then the maximum organic growth rate is g. If you grow less than g, you create excess cash (and leave value on the table), and if you grow faster than g, you need more capital infusion to grow at that rate (and have to run around to the capital markets or VCs etc!). As executive management, you want to minimize the number of times you go out with the begging bowl for capital!

So the objective of the business and management is to maximize this "potential growth rate" via capital efficiency, which in turn makes growth "self-funding" and minimizes the need for incremental capital. As the exponential equation above indicates, a higher g (or ROCE) for a given r also exponentially compounds value.

Net net: EFFICIENCY or productivity of capital is what GIVES the business THE LICENSE TO GROW & SCALE up, and sets an UPPER BOUND on maximum possible ORGANIC GROWTH RATE.

The corollary is that even when a business or initiative is "pre-revenue" or "pre-operating profits" - the emphasis is on frugal capital-efficient and time-efficient experimentation to discover the efficient operating model (aka a business model). Most aspects of growth business model design and the focus of innovation & technology should be around the above tenets of customer & operational/capital efficiency BEFORE you scale up or grow, and DURING scale up. We will look at the nuances of this in the rest of the article.

A couple of technical points: The ROCE has to be ideally estimated across an investment cycle since investments into assets are often lumpy, and returns are low (or negative) intially during the investment phase but spike up once the assets start getting utilized (aka "operating leverage"). Another reason is not to get confounded between experimentation costs (to discover the right model) and steady state model; or even the distinction in steady state between capital investments (i.e. fixed / working capital where capital is turned into balance sheet assets/liabilities) and operating profitability (i.e. conversion from sales to operating profits).

#2 a: Efficiency in the Early Stage of a Business

In an early stage of a business (whether in a startup or in a new initiative in a larger company), there may not be operating or net profits at the new business level. How do you evaluate ROCE and efficiency then?

The trick is to decompose the ROCE via the so-called Dupont formula (see below), i.e. into a first phase where capital/assets are converted to revenue or sales and then subsequently into a second phase from revenue or sales to gross profit, operating profit and net profit. The operating goal then becomes to get to a "path to revenue" (from initial assets and capital), followed by a "path to gross profits" and then finally "path to profitability" (operating and net profits) and "path-to-free-cash-flow".

The conversion of operating profits to free cash flows also includes netting out the fixed capital investments which needs to be paced carefully. We will discuss working capital aspects below. The goal is to get to sustainable trajectory of free cash flow growth.

Specifically, capital (equity and debt) is deployed into assets. Assets are used to generate sales / revenue / "turnover" and sales growth. More sales require more assets in general. The efficiency of conversion from capital to sales is measured by Asset Turnover Ratio or Capital-to-Sales (or Sales-to-Capital) ratio. Next sales convert into income or cash flows after subtracting costs. The efficiency of converting sales to income is called profitability or margins. Key margins are "operating margins" (pre- or post-tax), net margins, and margins of "EBIT", "EBITDA", "cash flow from operations" (CFOA), "free-cash-flow (FCF)" to firm (FCFF) and equity (FCFE). These are covered in the first article in detail.

A company that has high sales-to-capital ratio and low margins (eg: Walmart, Amazon retail arm) is very different from one that has low sales-to-capital ratio and medium-to-high margin (eg: a capital intensive industry). Google & Facebook (core ad / search / social businesses) have high sales-to-capital ratio and high and sustainable margins as well! A bad business is one that does not do well on both measures, and also has higher risk. When building a business (or valuing / analyzing an existing business), it is important to understand is what is the capital input (& timing) needed; and capital-efficiency, i.e. how well the business converts capital to sales and subsequently from sales to income or cash flows.

Another nuance to understand is that capital is deployed both in the balance sheet (fixed assets (long term) and working capital (short term)) shown above, and in the P&L (in cost-of-goods sold (COGS), SG&A (i.e. labor, R&D, sales etc)) shown below.

It is good to think of both of these as capital (not just accounting balance sheet assets), since often intangible long term assets such as software, branding, customer relationship, strategic & competitive investments are increasingly driving capital-to-sales conversion over the long term, and sales-to-profits conversion subsequently. It is important to maximize learning and then subsequently efficiencies of these capital investments so that they convert to sales. In a direct sales heavy organization, it is important to manage the sales cycle and account relationships to lower the average cost of sales over a cycle and over recurring sales.

#2b: Working Capital; Operating Income to Free Cash Flow Conversion:

Many laymen miss the fact that often the working capital investment is higher than the fixed capital investments. Note also that the "working capital" (WC) we have depicted on the asset side is technically split between current asset and current liability sides, but WC is defined as current assets minus current liabilities, since this is the incremental capital you need from equity or debt to cover. If this is negative, then you are funding your working capital from your stakeholders (suppliers or customers) and NOT your shareholders; and if this situation can be sustained, then you can grow faster since your equity/debt capital is used for fixed assets and intangible assets only; and working capital is making a net contribution as well. Fixed plus working capital is also referred to as "Capital Employed", and there is a corresponding measure ROC measure (esp in manufacturing companies) called "Return on Capital Employed"; or "Invested Capital (WC - cash)" and an ROC measure called ROIC "Return on Invested Capital".

Some of the key components of working capital are: inventory (reduce!), account receivables (reduce!), account payables (increase!), deferred revenue (increase!). Interestingly, the ones you want to reduce are on the asset side of the balance sheet; which says that it consumes capital which needs to be funded by either equity or debt on the liability side. For example when Amazon Pay holds your money or Tesla collects $100 reservations for a cybertruck or $6000 for Full Self Driving (FSD), it is deferred revenue, which is cash in the bank that slowly gets converted into accounting sales later. Similarly when a lean process in manufacturing has just-in-time inventory, there is less capital tied up in inventory to generate the same level of sales. Inventory could be work in process or finished goods in transition to a customer. This is important as the company grows, you want to optimize the incremental growth capital investment to fund the relative growth of items like inventory. Similarly if you pay your suppliers later, they are in turn funding your growth (Walmart, Amazon and the Auto OEMs are very good at this). WC is the net of all of this; and you need current liabilities to finance this.

Generally the goal is to manage the relative levels of these WC items as a percentage of sales, except inventory which is indexed to COGS. Lower WC / sales implies higher sales-to-capital ratio (one of the key determinants or components of ROCE). Working capital efficiency is a key form of operating efficiency especially in fast moving goods or capital goods with a long cycle from order to delivery (eg: retail, automotive, industrial).

Mathematically, the change in WC year-over-year also impacts how accounting operating profits or EBITDA converts over to "cash flow from operations" (CFOA). For example if the operating profits is $100, and WC year 0 was $500 and WC year 1 was $520, the CFOA is $100 - $20 (= 520 - 500) = $80.

Cash Flow from Operations (CFOA) then converts to operating free cash flow to the firm (FCFF) when you subtract out capital investments in that year (or period). The goal of a firm's management on the long run is to sustainable grow free cash flow to the firm, and ultimately to the equity shareholders (netting out debt payments, interest etc). A summary of the cash conversion cycle is below:

Jeff Bezos letters are a good read to understand how to optimize for free-cash-flows on the long term and over an investment cycle. A business that yields a great cash flow stream is referred to as a "franchise" (similar to the word franchising in retail where such a honor was granted to the franchisee who brings capital and operations to the table).

Please take the time to read the 2004 letter by Jeff Bezos: Free Cash Flow Per Share Tutorial by Jeff Bezos, 2004 Letter. It illustrates a company with positive earnings, EBITDA, but hugely negative free cash flow; which gets worse with the rate of growth. Over an entire investment cycle it destroys value. This example focuses on fixed capital investment impact, but a similar example can be constructed for working capital impact. Capital is capital - you can destroy it via fixed or working capital route! Be careful and efficient on how the capital is deployed and consumed in each cycle.

Net net, it is important to understand and setup a model with efficient cash conversion cycle PRIOR to growing and constantly manage the WC and FC investment aspects since that determines how free cash flow FCFF and FCFE is generated.

Remember that the value of the equity (which determines share price) is the discounted free cash flows to equity.

#3 Risk Mitigation: Anticipate downside to customer value or capital compounding, and invest in "insurance" to mitigate each of those contingencies.

Risk mitigation in customer value: it is important to invest in reliable / robust products that fail less often and minimizes need for costly field services. Manufacturing and constant testing for quality is crucial aspect, especially as you scale up. For example the Tesla model 3 has some teething experiences reported in early customers, but it was nipped in the bud before scaling up. Intel famously recalled a lot of chips to fix a problem. Reliable and experiential products give a recurring value stream of positive experiences to customers. Customers also feel the pain of negative experiences disproportionately and may relay it virally to other customers via social media or PR amplification via news outlets. It is important to invest in field service and warranty to build customer confidence and mitigate customer negative experiences in the (rare) cases when bad stuff happens.

The ability to fix problems and issues via IoT sensing for visibility and over-the-air software (OTA) updates is another compelling, scalable and lower cost way of risk mitigation for the future. This is the promise of "living products" that "grow" well beyond the capabilities when they rolled off the manufacturing line. This redefines the value of the product to the consumer over time. Also it enables learning from the fleet of operating products in the field both for product improvements in future products. When the feature / product is software driven (eg: autonomous driving), this flywheel of learning can lead to improved self-driving cars in the field via software updates (as Tesla is showing) as long as basic programmable hardware control platform and granular knobs for the mechanical/electrical stuff exist!

The next area of risk mitigation is in manufacturing / operations and in finance (capital structuring). In simple terms, the goal in operational risk management is to minimize variable costs (eg: cost of goods sold) or to have high gross / contribution margin, while ensuring quality controls and assurance on every unit shipped. Typically manufacturing displays economies of scale (i.e. lower operating/variable costs with larger scale) and learning economies (i.e lower variable costs with more units shipped). Investments need to be sustained and organization focus on learning in all aspects to capture these "learning curve" effects is crucial. The overall return on capital employed (ROCE), i.e. upper bound on growth rates, is realized over an investment cycle and improves with learning and sustainence of the customer value proposition relative to substitutes. This is also called "lean" in management speak, or "lean and mean" in colloquial terms!

In financial risk management, it is important to:

(a) adequately fund the company to cross the initial stages of de-risking, customer value creation, leaning the operations and any manufacturing / fixed investments, i.e. "crossing the chasm" to reach "escape velocity". Raise enough capital, but not too much (to avoid dilution)! Focus instead on frugal experiments & learning to get to sustainably high ROCE and lower risk.

(b) do not leverage up with debt till variances/volatility in incoming cash flows are resolved (i.e. debt - equity balance in the "capital structure"). Don't financial lever till you have smoother cash flows, especially the baseline cash flows to cover interest payments with a sufficient margin-of-safety!

Sometimes, for reasons of control and not diluting equity upfront, companies issue "convertible debt" which may have warrants attached (or governments may step in with "loan guarantees"). These dance around the debt-equity balance (looks like debt when the company is not yet successful; but as equity when the stock price is valued higher). These financial engineering options should be used with caution -- any debt is fundamentally risky prior to minimum cash flow levels since default or delinquencies will lead to loss of control of the company.

Summary:

There you have it. Fundamentally there are not three, but two aspects to focus on: efficiency (or returns or "rewards") and risk mitigation of contingencies (and targeted insurance). Efficiency gives you license to grow, and sets the upper bound & rate of capital compounding. Risk nets out the gains from efficiency via draw downs. Leverage is an insidious form of risk to avoid in volatile terms - better to raise forgiving equity than unforgiving debt! It is important to mitigate these points of risk via learning. A learnign mind set and a scale up/growth mind set in innovation and institutionalizing these via business design is therefore the secret.

Remember: do all of this BEFORE you scale up, and continuously widen the ROCE - WACC gap as you scale up over the investment cycle. This is the essence of building a great growth business whether in the context of a big corporation or in a startup.

This article is part of a series on Financial & Strategic Value Creation written for Technologists / techies: "Financial & Strategic Value Creation for Techies 101", "Financial & Strategic Value Creation for Techies 102: Analysis & Valuation", "Financial & Strategic Value Creation for Techies 103: Power of Compounding & Discounting", "Financial Literacy 104: Want Growth?", "Financial Literacy 105: Strategy Meets Execution"

PS: Selected older articles (2016-18): Blockchain/Crypto/Digital Tokens, Cashless Finance: UPI, Blockchain/Agri & Supply Chain Finance, Digital Agri: Commodity Spot / Futures Markets, Digital Agri: Future of Insurance, From Barter to Blockchain: Brief Journey of Payments & Ledgers, Cashless Financial Inclusion...

LinkedIn: Shivkumar Kalyanaraman 

Disclaimer: The views expressed here are personal and meant for information education purposes only and not representative of his employer directly or indirectly.

Twitter: @shivkuma_k

If you like this article, please check out these articles: "Financial & Strategic Value Creation for Techies 101", "Financial & Strategic Value Creation for Techies 102: Analysis & Valuation", "Financial & Strategic Value Creation for Techies 103: Power of Compounding & Discounting", "Electric meets Autonomous", "Commercial Electric Vehicles (EV) Fleets: The Stealth Growth", "Towards Affordable, Ubiquitous, Ultra-Fast EV Charging: Part 1: Need & Battery Issues", "EV Taxi Fleets & Ride Sharing: Poised for Huge Growth", "Shared EV Transportation in India", "Understanding the Rs. 3/kWh bids in India in 2017", "Distributed / Rooftop Solar in India: A Gentle Introduction: Part 1","Rooftop Solar in India: Part 2 {Shadowing, Soiling, Diesel Offset}", "Rooftop Solar in India: Part 3: Policy Tools... Net Metering etc..." "Solar Economics 101: Introduction to LCOE and Grid Parity" , "Solar will get cheaper than coal power much faster than you think..", "Understanding Recent Solar Tariffs in India", "How Electric Scooters,... can spur adoption of Distributed Solar in India," "Solar + Ola! = Sola! ... The Coming Energy-Transportation Nexus in India", "UDAY: Quietly Disentangling India's Power Distribution Sector", "Understanding Solar Finance in India: Part 1", "Back to the Future: The Coming Internet of Energy Networks...", "Tesla Model 3: More than Yet-Another-Car: Ushering in the Energy-Transportation Nexus", "Understanding Solar Finance in India: Part 2 (Project Finance)", "Ola! e-Rickshaws: the dawn of electric mobility in India", "Understanding Solar Finance in India: Part 3 (Solar Business Models)" , "Meet Olli: Fusion of Autonomous Electric Transport, Watson IoT and 3D Printing".

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