So often we hear or see something in the media about a particular business that has “made it”. Usually, it’s a fast growing startup that has grown out of someone’s garage into a “multi-million dollar business”.
Sorry to be the bearer of bad news but it is usually NOT a “multi-million dollar business”.
As a society, we seem to have this obsession that the value of the business is somehow the same as its sales volume. In other words, a business turning over $3 million is somehow a $3 million business, implying that it is worth $3 million. This is rarely, if ever, the case.
In my opinion, this focus on sales (and not true business value) is one of the factors influencing many business owners to chase volume (or sales) at the expense of building a sound, sustainable business over time and why we continue to see business failures reported on an almost daily basis.
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Value, not volume
It will therefore come as no surprise that my key measure of business success is business value, not sales volume. It follows that every decision a business owner makes should be predicated on building long-term business value.
Sometimes building value may be contrary to sales growth. For example, it is easier to build sales if you simply discount your prices. You’ll have higher and higher sales, but less and less profit. In my experience, this is a downward spiral to the bottom.
On the other hand, adopting a premium pricing strategy and differentiating your product may actually result in slower sales growth. This is not a bad thing. Your sales growth needs to be sustainable. However, if your cost of product remains unchanged then clearly you will make more profit under a premium pricing strategy than a price discounting strategy.
How do you measure value?
This raises an interesting point. How many business owners actually measure and manage their business value on a regular basis, say yearly? How many business owners actually develop strategy based on whether those strategies will increase value? How many business owners know whether a particular strategy will increase or decrease value?
From my 30-odd years of experience, the answer is very, very few. Everyone measures sales and everything else in the financial statements but very few measure their business value and whether they have added or destroyed value in their business.
In its simplest form, business value is added when the business makes a return (on capital employed) greater than the cost of the capital invested in that business.
The capital invested in any business has an opportunity cost. If that capital wasn’t invested in that business it could be invested in another business, in publicly listed shares or in interest-bearing deposits in the bank. Either way, that capital would get a return relative to the risk taken with the various investment classes.
When you choose to invest your capital into a business you need to ensure you’re getting an appropriate rate of return that reflects the risk taken. If your rate of return is less than the rate you need to compensate you for the risk on investing in that business, then you’re destroying value, not building value.
So why is there a predisposition to sales turnover? In my view, it’s simple: sales feed the ego of the owner or chief executive and it’s an easy metric to pick.
There is also an implicit assumption that if sales are growing, the business must be doing well. Wrong! Look at the corporate collapses in recent months and you’ll see quite a number that have been “fast growing”. I would say, growing too fast.
So, before you get excited (and envious) about some fast growing business you may see reported on in the media, ask a simple question – what was their return on capital employed? This is the true measure of business success.
Business owners need to constantly ask themselves the question: are my business decisions adding value or am I destroying value?
Grant Field is Australasian chairman of accounting network MGI and has 30 years’ experience, specialising in advice for family and privately owned businesses.
The information contained in this article is general in nature and readers should seek their own professional advice in relation to these areas.