Essential No. 5: Focus on Cash Flow

Having little or no long-term debt and being cash-flow positive early on are harbingers of success for high-growth companies

In the high-tech boom that peaked in 2000, we were treated to a rare phenomenon: Companies actually thought they could succeed without profits, and investors—for a few giddy months at least—seemed to agree. That phenomenon didn't last long.

Case in point: In 2001, Webvan drove off a cliff into Chapter 11 only 18 months after its IPO due to rapidly disappearing cash reserves. Webvan was too optimistic about consumers' willingness to ditch tedious checkout lines at regular grocery stores and flock to an online delivery service. While the quality of its service was rated as excellent, Webvan couldn't attract enough customers. One of the lessons from Webvan and the plethora of other dot-com companies that crashed is that overinvesting leading to negative cash flow is not the path to growth, especially if there are limited proof points indicating growing customer demand.

It seems like common sense that companies should seek to be profitable. In fact, only a minority are on a consistent basis. As of second quarter 2009, only 23% of all public companies with revenue of $100 million to $10 billion were achieving both positive cash flow and positive sales growth. Yes, not all companies that are achieving revenue growth are profitable. The masters can do both: grow their revenues and achieve positive profit and cash flow. While this may seem like common sense, this small percentage of profitable growth companies demonstrates just how difficult it is to do both.

Why are only 23% of businesses growing and generating positive cash flow? During turbulent economic cycles, management teams tend to swing to the extreme. During up economic cycles, optimism often leads investors and management teams to direct too much investment in research & development and sales & marketing, resulting in an overinvestment that results in the addition of debt. During a down market cycle, they cut R&D and sales/marketing investments to preserve cash while leveraging more debt to sustain the company through challenging times. This creates a vicious cycle of debt and over/under investment that drives a disproportionate number of companies to fail during periods of tight credit.

Early Profits

The success pattern of America's highest-growth companies is that they tend to be cash-flow positive as early as $25 million in revenue and grow a profitable business all the way to a billion or more in revenue and beyond. This is the success pattern of Cisco (CSCO), Google (GOOG), Microsoft (MSFT), Staples (SPLS), and many others across different industries.

When I started doing my research on The 7 Essentials and high-growth companies, I thought being profitable early and staying profitable seemed more common sense than an insight. Many of my readers and audience members at my keynote presentations also thought it was intuitively common sense, but the numbers told a different story. The disproportionate number of struggling companies saddled with high levels of long-term debt has shown how important achieving consistent growth with profitability is. Down economic cycles truly define the real growth companies: those that can be profitable while continuing to reinvest in R&D and sales and marketing.

What are today's benchmarks for becoming the masters of exponential returns? Utilizing the latest tools from Standard & Poor's, it is possible to identify America's best-run growth companies. As of the end of the second quarter 2009, companies growing to a billion such as Centene (CNC), HealthSpring (HS), and Flir Systems (FLIR) along with Stanley Works (SWK), Deckers Outdoor (DECK), and Texas Roadhouse (TXRH), which are billion-dollar plus revenue companies, are representative of the success pattern of America's best-performing growth companies.

Despite the challenging times, they are profitable, cash-flow positive, and generating high return on investment. These are the fundamental factors that drive above average returns to the shareholder.

The bottom line: Being consistently profitable, with low long-term debt, will enable you to grow through all economic cycles.

Insights to Actions

As your company aspires to achieve growth, here are three questions on the crucially important issue of profitability with reinvesting to grow:

• If your business is saddled with disproportionate long-term debt and low profitability, are you urgently focusing on a turnaround?

• Which management approach best represents how you are achieving profitability from gross margin earned: overinvest, cut costs, or balance profitability with reinvesting to grow?

• How well is your decision-making process working to prioritize investments and determine the optimal investment level?

Here are three actions you can take to become the masters of exponential returns even during the most challenging of times:

1. Focus on Cash-Flow Positive Performance Combined with Reducing Long-Term Debt

If your business is cash-flow negative with high long-term debt, the highest priority is to perform a thorough review of initiatives to increase gross margins and all expenses. Focus on achieving positive cash flow during these challenging times. While this is tough to do, it is imperative that your company join the ranks of the 23% growing and profitable companies.

2. Reinvest in Revenue-Growth Initiatives

America's highest-growth companies are reinvesting in new products and services to achieve revenue growth. These investments are highly capital-efficient.

Look for early signals that a small business (unit) has the potential to achieve exponential revenue growth. Focus on the growth rate, not the size of the business, to measure success. For example, after the launch of the first Staples store, founder Tom Stemberg knew he had an exceptional growth opportunity when the store achieved Year Four forecasts within the first 12 weeks. That was during the recession in 1986. Just over 20 years later, this business has grown to $20 billion in revenue!

3. Develop a Disciplined Process to Balance Positive Cash Flow with Reinvesting

A useful technique applied by growth companies is to withhold 10% of the planned budget to fund growth initiatives.

This process requires that management teams ruthlessly prioritize investments for the core business. The CFO often plays the role of the guardian of cash flow. The challenge is getting the team to trade off investments in one function vs. another for the good of the company.