The Growth of Business

The Growth of Business

There are two main ways in which a business can grow - internal growth and external growth.

Internal growth

(Often referred to as organic growth) refers to a situation where a business increases its size through investing in its existing product range, or by developing new products. This will normally be financed through the use of retained profits (from previous trading years), bank loans or, if the business is a PLC, through the issue of shares. This is a slower and safer method of expansion than external growth.

External growth

Involves much greater sums of money and takes place through the use of mergers and takeovers (often known as growth through amalgamation, or simply integration).

Regardless of the method of growth, there are several reasons why firms wish to grow:
  • To achieve economies of scale and see the average cost of production decline.
  • To achieve a greater market share.
  • To satisfy the ego of the businessman.
  • To achieve security through becoming more diversified.
  • To survive in an increasingly competitive market.

A merger occurs where two firms combine, with the consent of both groups of shareholders and Directors.

A takeover (also known as an acquisition) refers to a situation where over 50% of the shares in another company have been purchased - therefore giving the predator full control of the newly acquired company. Both mergers and takeovers are referred to as growth through amalgamation, or simply as integration.

There are several different classifications of integration:

  • Horizontal. This occurs when two firms in the same industry join together who produce the same product and are at the same stage of the production process (e.g. the Nestle takeover of Rowntree). The new, larger business is likely to be more powerful, have a larger market share, and achieve higher sales revenue and profits. However, the new business may become complacent and inefficient and find that it suffers from diseconomies of scale and / or falling profits.

  • Vertical. This occurs when two firms combine who are in the same industry, but at a different stage of the production process.

  • Forward vertical integration. Occurs where a company merges with, or takes-over, another company which is closer to the retail stage (i.e. nearer to the consumer). An example of this would be a car manufacturer taking-over a range of car showrooms. Forward Vertical integration is often the result of a desire to secure an adequate number of market outlets and to raise their standard.

  • Backward vertical integration. Occurs where a company merges with, or takes-over, another company which is closer to the source of the raw material (e.g. a car manufacturer taking-over a supplier of car components). Backward Vertical integration is often the result of a company being able to exercise much greater control over the quantity and quality of it supplies, as well as securing its supplies at a lower cost.

  • Conglomerate. This occurs where two firms merge which are in different industries and produce different goods - in other words, it is pure diversification. The major advantage to the new, larger firm is that it has diversified its product range and spread its risks.

  • Lateral. This occurs where two firms combine which are similar in some way, but are not in the same industry (e.g. Cadbury-Schweppes). Here, both companies produced products which were sold to similar market segments (confectionery and soft drinks). Often, the firms can benefit from the management and marketing techniques employed by the other.

The underlying motive for most mergers and takeovers is to achieve synergy. This is often called the "2+2=5 Effect", since the end result will hopefully be more than what the two firms put in to the venture.

If it is believed that a proposed merger or takeover is likely to act against the public interest, then it may be referred to the Competition Comission for investigation. In general, any merger or takeover which will result in a market share of 25% or more will be investigated by the Competition Comission.

This body does not have the power to take legal action against the company, but instead it can recommend to the Office of Fair Trading (O.F.T.) that some action needs to be taken against the recently merged companies.

The amount of finance required by a business will depend on a range of factors, including the age of the business, the track-record and profitability of the business, the industry that it is in and the state of the economy.

Internal finance is generated from within the business and is likely to come from one of three sources:

  1. Retained profit refers to profits made from previous years, which have remained after corporation tax has been paid to the Inland Revenue and after dividends have been distributed to shareholders. It is a useful source of finance to fund new products, etc.

  2. The sale of fixed assets, such as machinery, vehicles or even land and buildings which are idle, can also be a large source of cash to fund new projects.

  3. Making more effective use of working capital, such as chasing debtors for prompt payment, selling off any available stocks and negotiating longer credit periods with suppliers all release cash for use within the business.

External finance is generated from outside the business in a variety of ways:

  • Bank overdrafts allow the business to withdraw more money from the bank than it has in its account. It is a flexible, short-term method of borrowing extra cash. However, interest is calculated on a daily basis and it can be recalled at very short notice.

  • Trade credit involves the business obtaining goods from another business, but not paying for them for a period of time.

  • Factoring involves a business selling its debts to a factor company, who will immediately give the business 80% of the money owed to it by its customer. At a later date, having collected the debt from the customer, the factor company will give the business the remainder of the money less a fee.

  • Leasing is a common way to fund new fixed assets, as opposed to purchasing them outright. The business will sign a contract committing it to using some vehicles, machinery, premises, etc. for a fixed period of time (often 3-5 years) with a monthly payment made to the company who owns the assets. The business leasing the assets cannot put these items on its balance sheet (since it never owns them).

  • Loans and mortgages are often used to purchase new fixed assets (machinery, vehicles and land and property). They require monthly repayments to be made for a significant period of time (up to 25 years for a mortgage) and the bank will also want an item to be placed as security (collateral) to cater for the event of the business defaulting on it loan repayments. The danger is that too many loans and mortgages will increase the company's gearing to a dangerously high level.

  • Debentures are sold by companies to investors as a way of raising finance for use within the company. They are long-term, marketable securities, which will pay the holder a fixed amount of money every year until its maturity date - at which time the holder will be able to sell the debenture back to the company for it market price. However, debentures, like loans and mortgages, will increase the gearing level of a company.

  • Venture capital is a very risky type of investment that entrepreneurs (called venture capitalists) will make in a small to medium sized business, which they believe has massive growth potential. These funds will clearly help the business to grow and achieve its potential.

Whichever source of finance is chosen, the business must ensure that it is adequate for the needs of the business (i.e. it is enough to pay for the new product development, new buildings, etc.) and that it is appropriate (i.e. it will not leave the business with large monthly interest repayments, when they are already burdened with high gearing).

Rapid and unexpected growth can lead to a host of problems for businesses. Probably the most common problem is the effect that the growth has on the company's finances - specifically upon the liquidity and gearing of the company.

Extra expenses and increased long-term liabilities (such as loans and mortgages) may reduce the liquidity and increase the gearing levels of the company and leave it dangerously close to insolvency.

It may simply be the case that the managers cannot cope with the extra responsibilities and workloads that they are faced with - this could lead to a rapidly expanding workforce, with the problems of recruitment, training and lengthy communication channels that this will inevitably lead to.

It is also possible that the company may become inefficient and it may experience diseconomies of scale (rising average costs). This could lead to a significant fall in profits, which in turn could persuade shareholders to sell their shares - this would result in a falling share price.

A major problem that a PLC can experience as it grows is the divorce of ownership and control. This refers to the fact that the owners of a PLC (shareholders) are usually interested in maximising the company's profits and, therefore, their own dividend payments. However, the control of the company is in the hands of the management and the Directors. They too want the company to be profitable, but would also like some of the company's resources and money to be invested into new products and new markets.

This, clearly, reduces the short-term profits of the company and, therefore, also reduces the dividend payments to shareholders.

Management Buy-Outs

Management Buy-Outs involve the management team buying an equity stake in the company that they work for (i.e. they become the owners, or part-owners, of the company). Each member of the management team will be expected to invest much of his own money into the venture, but the majority of the finance required to buy the company will come from financial institutions and from venture capitalists.

One of the most common examples of Management Buy-Outs is when the management team of a company that is facing receivership decides to buy-out the company, rather than let it be acquired by an outside organisation.

The management team, when deciding whether to buy-out the company, should make an assessment of the business in terms of its cashflow, profitability, product range, assets and the different markets in which it operates. If the company looks as if it has potential, then the management team may well take the risk and buy-out the company.

The managers often make a success of such a venture because they are more in touch with the workings of the company and with the markets in which they operate. The managers are often a highly motivated group of people and they realise that the success or failure of the company rests with their activities. An example of a Management Buy-Out that was a tremendous success was Denby Pottery, and one that failed was M.F.I.

Management Buy-Ins

Management Buy-Ins exist where the management team of an outside company buy enough shares in another company to control it. The managers buy the shares because they believe that they can run the company more efficiently and profitably than the existing management team. A Management Buy-In is likely to be financed predominantly through borrowed funds, which will cause the gearing ratio to be high.

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