When Profitability Is The Wrong KPI To Use
2 July 2021
Since debt financing is essentially free in our current economic environment, companies should consider switching their focus to investing and accelerating growth rather than improve profitability. This is what Michael Mankins argues for in his 2017 Harvard Business Review article. Learn the reasons why many companies resist growth even under these excellent conditions to invest in growth.
The default performance indicator for many businesses is profitability. Profitability is defined as “the state or condition of yielding a financial profit or gain. It is often measured by price to earnings ratio.” It’s a measurement of efficiency, yet it’s important to understand that a company can realise a profit without being profitable. Companies today that are hyper-focused on profitability in our current economic reality are being held back, because the scales have now tipped in favour of accelerating growth rather than improving operating margins.
Low Capital Costs Equate to Accelerating Growth
Right now, there is a capital overabundance due to companies hoarding cash and trimming costs in response to the global financial crisis. And it hasn’t just grown, global capital balances have more than doubled between 1990 and 2010. For most companies, this excess capital combined with slow economic growth means low capital costs. Today, the average cost of equity capital is about 8%, just about half of what it was for much of the 1980s and 1990s. This creates a situation where debt financing is essentially free. In this situation, when the cost of money is low, the promise of making more money in the future through growth initiatives is extremely appealing and potentially a better bet than earning a few extra dollars in the short term with a focus on profitability.
Although the trade-off between profitability and growth is different for each company, generally, we’re in a time when most companies should embrace strategies to create faster growth.
Why Do Companies Shortchange Growth?
Even when conditions are ripe to focus on accelerating growth, companies still resist in favour of cost-cutting initiatives. A recent Reuters report found that spending on R&D and new capital expenditures remained lower than what companies devoted to share purchases last year. Why are the majority of companies undermining their success and stilting growth initiatives?
Here are just a few of the reasons:
1. Good ideas aren’t always abundant
Many companies focus their team’s talented minds on ways to reduce costs and improve efficiency at the detriment of brainstorming the next best idea or innovation that would lead to growth. Just think if Apple was only concerned with cutting costs and improving profitability and never devoted a team to dreaming and developing the iPhone. Companies need to nurture a culture that values a growth mindset to encourage the risk taking that is inherent when looking for new ways to grow. In addition, teams need to have the bandwidth to explore new ideas and innovate. If they are already over tasked with keeping up with today’s business, there will be no time to develop ideas that could catapult the company’s future success.
2. Constrictive processes that eliminate many growth options
When growth is an objective, it is important to ensure that the screening processes for investment aren’t just focused on “sure bets.” The parameters for what makes an investment attractive should be widened in a time of low capital costs. It’s safer to explore and experiment with a wider range of new possibilities for growth. Companies that fuel growth open the idea funnel wider and experiment with more than “sure bets.” They are quick to spot and shut down concepts that don’t show early promise after initial vetting, but are also willing to invest significantly in those concepts that do show promise.
3. Not enough resources to devote to growth initiatives
Most companies aren’t resourced enough to properly dig into great ideas and make them successful new services, products or business lines. If your organisation is going to propel growth, it needs human capital to drive it. It’s also about having the right people in the right positions to make the biggest difference. Those high-performing employees need to have the time available to brainstorm what could be the next big thing and work on it without too many constraints from the leadership team and other established processes.
It might be time to shift your mindset and your performance indicators from being focused on profitability and instead go for growth. Even though your organisation may have obstacles to growth, the rewards of taking advantage of low capital costs and investing your team’s time, talent and your organisation’s money to develop new products, services and business today make it worth your effort.
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