Just like the circle of life, companies too are born, they grow and develop, mature, they begin to decline, and eventually (in many cases) they grow old and die. The lifecycle shows the progress of the business in phases over time, which can impact its numbers. Let’s find out by understanding the business cycle.
Pilot phase : An idea is born, perhaps to launch a new product or service. For example, if starting a tiffin delivery service, the low visibility of demand at the initial stage gives the business the added benefit of only bearing variable costs for vegetables and other ingredients. The absence of fixed costs (FC) gives the company the opportunity to generate unprecedented gross profit (GP) and net profit (NP), profit margins and even a return on investment at the highest level ever! Unfortunately, this does not last very long!
Start: This is where the conversion of a great business idea into a commercially viable product / service occurs. But this also comes with huge capital investments (FA) to meet the growing demand expected in the years to come. Say industrial grade cooking appliances for the tiffin business. Unfortunately, 95% of companies fail in this step itself because they are unable to truly project the demand, FC and FA investments of the not-so-sustainable euphoric pilot phase! To gain the distributor’s confidence, selling on credit is essential! This in turn speeds up the cash conversion cycle (CCC), which only decreases once the business enters successive phases. Due to high credit sales, low purchasing power, and working capital requirements to run day-to-day operations, start-ups expect to see negative operating cash flow (OCF) during the first few years. steps. With increasing investments in FA (low core but fast growing) coupled with low income (increasing slowly and steadily), the asset turnover ratio (AT) and return on invested capital (ROIC) of the business are at the lowest here; again, gradually increasing in the stages to come.
High increase: Here, companies will experience extremely high revenue growth, with some even managing to double their revenue (year-on-year) only because of the extremely low base in the initial phase. However, GP and NP still remain high; but not as much as in the previous steps. The CCC also remains high, but decreases comparatively because credit is still king! With rapid sales growth and spending stabilized, finally, OCF has a chance to turn positive. As income still fails to catch up with growth in the asset base, TA and ROIC may remain low.
Slow growth: As these businesses start to age, revenue growth tends to slow down as they now rely on a larger base from the early stages. In fact, given the huge base from which it is growing, even lower sales growth is much more impressive now. Nevertheless, sales are at their highest level and the ROIC is high. Profits may still increase, but now at a much slower rate. OCF is growing and even manages to exceed profits; which makes it the best time to invest in these proven companies that have withstood aggressive competition and market saturation. Reputable companies may even benefit from bargaining power from both supplier and customer, further reducing CCC.
Maturity: When a company reaches maturity, its turnover changes little from one year to the next. Here, GP will stagnate and NP will decline even more as diseconomies of scale set in. ROIC. With bargaining power, money is now king and the CCC is at its lowest. Depending on management decisions, companies can choose to pay large dividends, with buyout stocks often funded by debt pushing toward a high D / E ratio. In any case, if a company’s investment is approaching the end of the maturity cycle or is about to enter a phase of decline, it is better to take your money and get out because what will follow risks be a big disappointment!
Decline: In the final stage, the income will decrease and the cash flow will also fall, as the business makes less profit. This is where you start to reap the business, the dividend policy comes into play. Businesses lose their competitive edge, either accept their failure and call for it to resign, or move on to other lucrative avenues, prolonging thus the life cycle. The business lifecycle shatters the myths of âbig safe, small caps riskyâ.
Koushik Mohan is the fund manager of Moat Financial Services.
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