As most business owners will tell you, there is perhaps no single factor more important to a company’s financial success than its ability to generate revenues. After all, if a company cannot sell its product or service, how can it make money? Furthermore, growth in revenues can often serve as the primary driver in increasing a company’s value. However, as you will see in this post, revenue growth does not always translate to appreciation in business value. There is much more to the story, as they say.
The first example relates to the assets that are required to generate revenue growth. For example, take a business that generates revenues by manufacturing products. In many cases, manufacturers grow revenue by expanding production capacity in the form of additional machines or a new plant. Of course, these new assets cost money to purchase and operate (capital expenditures, repairs, maintenance, supplies, labor, etc.). The real culprit, however, is the means by which these expensive assets are purchased. If the purchase is financed with new debt, the business will now be burdened with additional expenses (interest on the debt) and cash outflows (debt repayments). Presumably, the increased profitability realized from the higher revenue levels will cover the debt service, but it may take the business time to fully realize the financial benefits of the purchase.
In addition to the need to make investments in fixed assets to grow a business, a company will often require increased investment in working capital to support revenue growth. As a company’s revenue levels increase, so too must its accounts receivable and inventory levels, which tie up resources of the company in non-cash items. As a result, even as a company’s revenue and profits grow, a portion of those profits typically need to be kept in the business in the form of additional working capital, meaning that this profit is not available for distribution to owners, which has an impact on value.
Another common issue we face as valuators is when a company decides to cut its prices. Prices are often reduced in an effort to increase sales volume (products sold) and can sometimes generate increased revenue for the company (if enough additional sales are generated from the price cuts). The company’s cost structure, however, tells a critical part of the financial story. If prices are reduced with no corresponding reduction in costs, however, the company may suffer from diminished margins and lower earnings unless items sold.
On the other hand, if the company can hold down costs while at the same time growing revenues, the company realizes “the best of both worlds.” This is very common for companies with a cost structure that is heavily fixed in nature. The ability to take most or all of an additional dollar of sales all the way to the bottom line earnings can measurably increase the value of the business due to its superior cash flow.
There are numerous factors that can impact the value of a business beyond revenue levels and revenue growth. Of course, revenues serve as the starting point from which all cash flows are generated, so their importance must not be understated. That said, next time you hear about a company that is growing revenues at a great clip, remember there is likely more to the story.