By James McCusker Business 101
Many businesses are seeing increased sales and owners and managers are feeling more confident than at any other time in the past three years.
They are right to have a good feeling about their businesses. If they made it through the past three or four years, they have every reason to believe they can handle anything that comes at them in the future.
They are proven veterans now, still standing and ready to take a hit and keep competing. Still, they may not be as ready for success as they should be.
Business growth offers a very different set of management challenges. And it would be truly a shame for a business that weathered the worst that an economic depression could throw at it to falter and fall at the hands of the recovery.
A reminder of one of those challenges was prompted recently by a discussion at a dinner shared with some old friends. Most of them have their own businesses and have dealt with some painful decisions forced by the effects of this recession. One, though, when faced with shrinking demand in his primary business chose to diversify into an unrelated market.
It turned out to be a smart decision. As his primary business stabilized and began the long slog to recovery, the new business tapped into what turned out to be a strong, unmet consumer demand and the enterprise is experiencing remarkably rapid growth. It’s all good, but he is now facing a classic decision in risk management.
Essentially, the decision involves a tradeoff between market risk and financial risk.
The new business is an equipment-based service, and demand for it far exceeds even the most optimistic initial estimates. The current limitation is the equipment and he reports that demand is so strong that each new unit is running at capacity as soon as it is brought on line.
For those of us involved with businesses that have been on austerity diets for years, his situation sounds like a sweet place to be, and it is.
Sweet isn’t always risk-free, though, at least in business.
A business with growing demand for its product or services faces two general categories of risk: market risk and financial risk. Market risk can be looked at as a type of competitive risk: If you don’t grow to meet customer demand someone else will. Financial risk is a calculation of how much money you would lose if you overshoot the market, create expensive idle capacity and leave your business “all dressed up with no place to go.”
Overshooting the market can be the result of simply making a mistake when estimating the size or the potential growth of the market for your specific product or service. It is easier to do than you might think despite today’s array of headache-quality math, computerized precision data bases, shrink-wrapped consumer behavior analyses and sophisticated business models. There is a long list of things that can go wrong when predicting future demand.
You can also overshoot the market if it is affected by some outside force that causes a shift in demand for your product. This can be caused by deteriorating economic conditions or a technological innovation that changes the appeal of your product or service.
In our example case, the business owner decided to minimize the financial risk by bringing new hardware on line only as it could be funded by either operational profits or additional capital investment. This limited the financial risk to the amount of money used to purchase the equipment, but also limited the rate of growth.
This strategy minimizes the financial risk and maximizes the marketing risk, and appears to be the best fit for both the economic conditions and the new enterprise’s management structure which is designed for incremental growth.
The alternative for most firms facing such a strong demand is to shift the balance from market risk to financial risk by borrowing money to finance the hardware needed for rapid growth. Borrowed capital — leverage — is tax-friendly, can certainly allow a firm to grow more rapidly and in many cases to accumulate more profit. But it also magnifies the total risk for the firm.
Both market risk and financial risk can be lethal for any business, large or small. Market risk miscalculations, though, usually allow some time for a business to reinvent itself and direct its products and services to a different market or market segment. A mistake in gauging financial risk, by contrast, often pushes a leveraged business at eye-blink speed from concern to desperation to turning out the lights.
Balancing market and financial risk is not always easy, but understanding these risks makes your business likely to enjoy success rather than collide with it.
James McCusker is a Bothell economist, educator and small-business consultant. He can be reached by email at firstname.lastname@example.org.