Whether business growth happens through internal expansion or external acquisition, borrowers share certain denominators. They usually need more capital — either debt or private equity — to achieve their objectives. And these business owners may tend to overestimate how they expect to perform while underestimating timing and financing constraints.
Lenders can serve as the voice of reason by 1) requiring borrowers to provide financial statement projections and other analyses, and 2) reviewing expansion plans skeptically. In other words, ask key questions before approving an expansion or acquisition loan.
Borrowers have several expansion strategies from which to choose. And lenders should analyze these tactics carefully.
Experience natural growth
Borrowers can take the slow and steady path by stepping up sales themselves. Internal growth strategies include building a new plant, purchasing new machinery, developing a new product or service, or expanding into new markets.
Building from within isn’t without drawbacks. Management must devote significant time to marketing and selling, which means there’s less time for normal operations. This can be especially disruptive for small businesses that rely on a few key individuals. Likewise, integrating new equipment or facilities can consume time at the expense of existing sales and customer service.
Additionally, new products might cannibalize existing ones, or a new target market might reject a product extension. Preliminary tests — free trials, surveys and focus groups — are inexpensive ways to avoid costly marketing miscalculations.
Buy another company
One fast track for growth involves buying another business. An acquisition typically provides assets and an established track record, including immediate cash flow, an assembled workforce, a pre-existing client base and customer referrals.
Business combinations make the most sense if the value of the combined entity is greater than the sum of its parts. So, acquisitions should create value via economies of scale, operating synergies and cross-selling opportunities. Competitors are obvious acquisition candidates.
Acquisitions don’t always pan out, however. Potential reasons for failure include incongruent corporate cultures and seller misrepresentations.
Successful transitions usually require the seller’s ongoing efforts. In-depth due diligence also can minimize acquisition risk.
Enter a joint venture
Joint ventures and other contractual relationships with other companies, such as licensing and franchising, allow businesses to grow with minimal capital infusion. By starting slowly, two organizations can test their congruence and, if compatible, add incremental layers over time.
Borrowers face many growth opportunities but generally have limited resources to pursue all of their ideas. When prioritizing and selecting expansion alternatives, projected financial statements are useful tools.
Typically, projections start with an expected percentage increase in sales. Then, the growth rate flows through to other items that are related to sales, such as inventory, receivables, payables and variable expenses. Thorough projections depict all three financial statements: the income statement, balance sheet and cash flow statement.
CFOs and accountants often use debt as a “plug” figure to balance their projections. This figure is particularly helpful for lenders, because it shows how much, and when, loan proceeds will be needed. Historic results provide an important frame of reference when reviewing projections.
Don’t rely on projections alone
One problem with projections is that they ignore the time value of money. That’s because, by definition, they describe what is likely to happen given a set of circumstances. So it’s difficult to compare detailed projections against other investments a business might be considering. As a result, other financial tools, such as a net present value analysis and an internal rate of return calculation, generate comparative metrics.
Your customers’ expansions don’t come without growing pains. Examine their strategies carefully before issuing new loans.