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How to Identify Opportunity and Innovate

Most million-dollar ideas are a complex combination of genius, timing and luck but here’s the good news – anyone can create an environment that is conducive to breakthrough thinking and innovation.

Greg Fisher

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Fifty years ago it was access to capital that set you apart – people who had money were generally in a better position to make more money. Now it is the quality of your business concept and your ability to execute it that positions you to create real wealth. In this environment it is possible for a twenty-something student to write an inventive computer code, launch a business, and if the computer code is found to be useful, generate more than a billion dollars – think Google, Mark Shuttleworth, Yahoo, YouTube or Facebook. For others, it may be a slightly longer, more arduous process but all around you people are discovering sources of new wealth in the form of exciting new business ideas.

We all want to know how they do it. Where do those big ideas come from and how could we put ourselves in the position to uncover the next million dollar idea? The truth behind most million dollar ideas is that they are a complicated combination of timing, genius and luck.

Entrepreneurship is a practice that is part art and part science. As a scientist, the entrepreneur needs to apply basic business principles and laws and as an artist they need to break with convention and do things that are out of the ordinary and novel. This article will provide a practical framework to uncover viable, exciting, creative business ideas by exploring the sources of new business opportunities and highlighting some tools that can be applied to uncover and capture those opportunities.

New opportunities generally emanate from change. Entrepreneurs respond to change in an innovative way to create new value. Peter Drucker said: “The entrepreneur always searches for change, responds to it and exploits it as an opportunity”.

Such change may have already occurred or be underway. Therefore, if you wish to see opportunity you need to be aware of change. I have built on the framework of Peter Drucker to identify seven distinct sources of new business opportunity.

1. The Unexpected

One of the richest sources of new business opportunity is unexpected success. This is what happens when, after a period of tinkering and messing around, you wake up one day and realise that you have created something that may be of huge economic value to others. Three of the world’s largest Internet companies were the result of unexpected success. Google was created out of a PhD project in which Larry Page and Sergey Brin were just trying to create something interesting for their dissertation at Stanford. They had no intention of creating a business and only founded a company when no one else would buy their technology. Yahoo and eBay both had similar origins: their founders were messing around with the Internet with no intention of launching a business but both stumbled upon valuable concepts that they later turned into billion dollar businesses. Unexpected success is not limited to Internet start-ups. Raizcorp, the highly successful South African business incubator was born out of Allon Raiz’s efforts to assist some of his friends clean up their business operations. He was driving from one business to the next imparting advice and assistance and thought to himself: “Would it not be more productive for me to bring all these businesses under one roof”. Before he knew it he had a business incubator which has evolved into an innovative profitable business that is respected across the globe.

Your chance of uncovering unexpected successes will be enhanced as you tinker and experiment. It is for this reason that 3M insists that all of its employees spend 20% of their time working on personal projects. The tinkering from those personal projects often evolves into a new product or a new line of business. Unexpected opportunities emerge out of the act of serious play. As Michael Schurge of MIT said: “You can’t be a serious innovator unless and until you are ready, willing, and able to seriously play. ‘Serious Play’ is not an oxymoron; it is the essence of innovation.”

In order to harness the opportunities offered by the unexpected you need to be open-minded and alert. So many unexpected opportunities are passing people by every day. Because they are so focused on what they are doing, they ignore opportunities that may be staring them in the face. “Chance favours the prepared mind,” said Louis Pasture.

2. The Existing

Existing business ideas are ideas that are “borrowed” from others. In South Africa this is a viable and promising strategy for uncovering new business opportunities. Due to the country’s geographic location and relatively small population, many innovative global companies ignore it as a market. This enables others to “copy” their innovative ideas and establish thriving businesses in South Africa. In 1985, Naspers sent a representative to the United States to study the pay television industry and out of this M-Net was born as a concept borrowed from cable television networks in North America. Kulula.com was founded after Gidon Novick spent time doing his MBA in the US and discovered the low cost airline models abroad. He realised there was huge opportunity for a low cost airline emulating Southwest, Easyjet and Ryanaire in South Africa.

To uncover existing ideas, spend some time exploring large developed markets. Look for products and concepts that are new, innovative and exciting and that could be implemented in South Africa.

3. Incongruity

An incongruity is a discrepancy between what is and what ought to be. It is something that is “out of sync” with what makes logical sense, but is often overlooked because people get used to the status quo. In the 1950’s, the general view was that ocean freight would be replaced by airfreight because ocean freight was slow and risky. It took so long to load and off-load that often cargo would be spoiled or stolen while it waited on the docks. Many people predicted the demise of shipping companies, yet, in 1956, Malcolm McLean invented the simple but revolutionary idea of a standard-sized shipping container that could be loaded onto ships, railcars and trucks. It changed cargo shipping from a messy loss-making labour-intensive process to a viable equipment-intensive process. Today the ocean freight industry is thriving because of McLean’s recognition and response to the incongruity in the existing shipping process. In South Africa, the Automobile Association has effectively recognised and responded to an incongruity in the second-hand car market. Sellers fear being hijacked when taking a prospective buyer for a test drive and they don’t know how to safely facilitate payment for a second-hand vehicle sale. Buyers fear they could be sold a “lemon”. AA has responded to these incongruities by establishing AA Autobay, a service that provides inspections of private cars before they are sold, brings buyers and sellers together at safe AA locations and facilitates payment for car sales within a predefined and controlled process. They take a small commission for providing these services. I predict that AA Autobay will save private used-car sales from a certain death in South Africa.

The reason that we miss incongruities as new business opportunities is that we become oblivious to them. We accept subtle problems as “that is just the way it is” without asking questions like “what if we could solve that?” or “how could we solve that?” Those who attempt to answer the “what if” or “how” questions in a sensible, systematic, creative way inevitably uncover exciting new business opportunities.

4. Industry Change

An industry structure is a description of how the various participants within an industry interrelate. Participants in an industry include buyers, sellers, competitors and financiers. The four highly visible indicators of impending industry change are:

  • Rapid growth within an industry.

As an industry grows so power shifts and new opportunities open up. Government spending on infrastructure development in South Africa gave rise to rapid growth in the construction industry creating a plethora of new opportunities.

  • Convergence of technology.

This means that a number of industries merge together giving rise to new competitors, new markets and new opportunities and niches to exploit. The convergence of wireless technologies (cell phones, computing and television) is fuelling growth for some of South Africa’s largest companies such as MTN and Vodacom, while providing fertile ground for the emergence of new companies such as Leaf Wireless and iFind.

  • Deregulation and new legislation.

Changing laws cause power shifts within an industry and those who can correctly predict how the power will shift can seize new opportunities. Derivco, a Durban based company emerged as a leading developer of software for the online gaming industry internationally because in 1996 the founders realised that the laws in the gambling industry were changing. They recognised that the change in laws and emergence of the Internet would give rise to a whole new gambling system. They built the back-end for online gambling, seizing a huge opportunity to become world leaders in that niche.

  • Business practices are shifting.

Over time the accepted practices within an industry may change and this inevitably gives rise to new opportunities. The increased use of the Internet by retailers was the change in business practice that opened the door for Mark Shuttleworth to create Thawte Consulting, the online security company that he sold to Verisign for $575 million.

try this Using industry change as a source for new business ideas involves monitoring the regulations, relationships, practices, technology and growth within an industry. When changes are evident, one needs to critically assess the impact and likely outcome of the change and judge where the new opportunities will exist as a result of such change.

5. Demographic ShiftS

Demographic shifts are changes in a population, its size, age structure, composition, employment patterns, educational status or income. They are generally clear and measurable changes, unambiguous in nature, with predictable consequences. Many notable shifts are currently taking place. In the developed world, populations are aging, giving rise to a range of new business opportunities in healthcare, travel and retirement planning. In South Africa, the emergence of a black middle class created opportunities for new retail outlets, new schools and new residential housing complexes. All of this is so obvious that you would think there was no need to be reminded of the importance of demographics; yet, many businesspeople ignore the simple reality of demographic shifts.

Demographic statistics are the starting point for gauging opportunities, but the key is to interrogate the numbers and ask:

  • What do the demographic shifts mean for our current business?
  • Are there going to be under-served needs in
    the future?
  • Could we provide products or services to meet those under-served needs?

With a little effort, details on demographic shifts are easy to find. Most census bureaus publish their information on the web and many marketing research houses and consulting firms publish demographic details for different sectors of the population. A simple Internet search will give you access to details of expected demographic shifts in sectors of the population. You just need to be inquisitive and conscientious to find the details.

6. Altered Perceptions

Perceptions change. That is a reality of life. Anyone in the fashion, design or retail industry knows this fact all too well. But, it is not only fashion related businesses that need to be conscious of changes in perception. Any business that connects with a consumer, directly or indirectly, will be impacted by changes in perception. Changes in perception create wonderful opportunities for entrepreneurially orientated companies. Woolworths responded to changes in perception about health and personal time with a wide variety of healthy pre-packaged meals. Cape Storm, the outdoor clothing and equipment company, was founded in response to the trend towards adventure orientated sports and activities.

Changes in perception can be difficult to interpret and starting a business in response to changes in perception can be risky. Perceptions are fleeting and often unclear. Therefore, one needs to be cautious when using perceptions as sources for innovation and new ideas. Peter Drucker says: “There is nothing more dangerous than to be premature in exploiting a change in perception…a good many of what look like changes in perception turn out to be short-lived fads, and they are gone in a year or two.”

If you are relying on a change in perception as a source for a new business idea ask yourself these questions:

  • Is this a genuine shift in perception?
  • How long will people perceive things in this way?
  • What could happen to cause a further shift in perception, making my original idea relevant?

7. New Knowledge

Knowledge based innovation is what many perceive to be the panacea of entrepreneurial activity. Knowledge-based innovations attract publicity and attention. The development of new medicines in the biotechnology industry, the development of new computer codes in the software industry and the attempt to uncover new sources of energy in many areas of science, all represent knowledge-based innovations. Knowledge-based innovations, in spite of being very valuable, popular and important in society, are also very risky. Such new business ideas often have long lead times, heavy financial investments to get them to market and very uncertain outcomes. Those that succeed create massive amounts of wealth for the entrepreneur, such as Bill Gates in creating Microsoft or Robert Noyce in founding Intel, but the many others that fail result in loss, frustration and despair for the entrepreneur.

If you are considering opportunities to apply new knowledge to create a viable new line of business think about:

  • The development of technology.

Can you predict how technology is developing in a particular field and could you engage in a process to create the next major improvement in a particular technology?

  • The convergence of technology.

Do you foresee certain technologies linking up and does this create new opportunities?

  • The emergence of new technology.

The opportunities created by new technologies such as the Internet or mobile phones when they first emerged were very significant. New knowledge usually emerges from research laboratories. Emerging new technology is hard to find but if you do uncover something that is currently on the fringe and promises to go mainstream, then with the right kind of investment, you could become very wealthy.

Finding new ideas is one of the most fun, exciting and engaging aspects of business but it is also one of the most challenging and frustrating processes that you can go through. The joy of discovery can put you on an emotional high but the energy required to be effective in seeing new business opportunities can be draining. Many people are tempted to avoid this process. They realise that it is easier to just go on doing what they have been doing. But then one day they wake up and their business is no longer relevant. Engaging with new ideas and new opportunities is part of staying relevant, profitable and successful, in your personal and business capacity.

Tools for Uncovering New Ideas

Just knowing what gives rise to new opportunities is not enough. You need to position yourself to see, capture, evaluate and build on new ideas. The primary mechanism for doing this is an alert mind and an inquisitive spirit. To awaken your mind and foster your spirit you can: explore, experiment, record, research and track trends.

Explore

Go on exploration journeys

An exploration journey is a trip that you make to learn from what you see and feel as you immerse yourself in a new experience. An exploration journey could be a trip abroad for a number of months or it could be a journey of a few hours to observe how your clients use your product so that you can look for opportunities for radical improvement. In 2006, Koos Bekker, the innovative and highly successful CEO of Naspers, the company that owns M-Net, Multichoice and a host of other media investments, announced he was taking a six month sabbatical. He set aside time to travel around the world and engage with people about how the technology landscape was shifting. He felt that he needed this deep, rich, immersive experience to get an idea of which direction Naspers needed to go next. In an interview midway through his exploration trip, Bekker described the incredible insight he had gleaned and the new ideas he had generated.

He spoke of the democratisation of media, the entrepreneurial opportunities that are emerging for skilled young computer geeks, the importance of broadband and how government needs to allow people to experiment.

An exploration journey can assist in uncovering business opportunities emanating from a number of different sources including incongruities, altered perceptions and existing opportunities.

The characteristics of a useful exploration journey are that it is:

  • Engaging. It is an active experience. You get the opportunity to engage first hand with either experts or customers/users and learn from their experience.
  • Broad. It has a broad and sometimes ill-defined purpose. If you make it too specific and narrow in purpose, you often shut out important things that you could learn.
  • Captured. The insights and inspiration from the trip are recorded in an effective way. Using a combination of digital photographs, video, an idea journal and/or a voice recorder, you need to capture and consolidate what you learn on your journey.

Experiment

Engage in active experimentation

Experimentation is the activity of tinkering with different ideas, quickly building prototypes of new products or offering a new service to a small client base for a limited period just to test it out. Experimentation has been consistently linked with highly innovative activity in small start-ups and big, world class companies such as Google and 3M.

Productive experimentation is:

  • QUICK. Building prototypes and experiments to test out and play with new concepts should be a speedy exercise. The idea of experimentation is to quickly learn what works and does not work. “Fail fast to succeed sooner” is the motto of effective experimentation, as pointed out by Dave Kelly in The Art of Innovation.
  • Tangible. If you are in a product-orientated business, quickly build a mock-up of your idea using whatever materials you can find. If you are in a service business, quickly emulate the service you wish to create and see if it works.
  • Rough. Experimentation is not about being perfect. Many people avoid tinkering because they want what they produce to be perfect. The purpose of being in experimentation is to avoid perfection and focus on action and output.

Record

Keep an idea journal

Every innovative businessperson I have met has a mechanism for capturing ideas. Many use what I call an idea journal – a small, accessible book in which they can capture thoughts as they spring into their head. They scribble, draw diagrams, jot down key words or merely record a reference or website address that they can use at a later stage. A simple, easy to access book that you can keep in your pocket is all you need to start.

For an idea journal to be effective make it:

  • Readily accessible. You must keep it in a place where you can access it whenever you see or hear something or when an idea pops into your head.
  • Your own. Write and scribble in it in your own style.
    Don’t worry about whether others will be able to decipher what
    you have written.
  • Lasting. Don’t throw away idea journals. You never know when you may want to go back to something you thought about or saw a few years ago. Once a book is full, label it and file it in an easy to access location.

Research

Develop a research orientation

With the growth of the Internet, the world of information has opened up for everyone. Access to information used to be for the privileged few and as a businessperson you would need to pay a marketing research company to summarise important data for you. Now, much of that data is readily accessible on the web, and all you need is the ability to search for it and evaluate what you find. Information can give you huge insight into where opportunities exist. Many people feel intimidated by information or are too lazy to search for it. If you can learn to find and use effective research data, you can create a distinct advantage for yourself or your business.

To develop an effective research orientation you should:

  • Learn to search. There is an art to searching, or using a search engine. There are ways of describing what you wish to find that can make your Internet search far more effective and targeted. (www.googleguide.com is a good place to start)
  • Systemise your findings. It takes a bit of effort to store
    and label what you find but it can pay big dividends over time.
    You will be surprised by the number of times you wish to go back to something that you previously found on the Internet and if you have stored the reference or file in an easy to access location then you will be able to benefit from all your previous research as you build new business ideas.

Track Trends – Monitor changes in trends and perceptions

Tracking trends can be tricky. It is difficult to distinguish between a true trend and a short-lived fad. But tracking trends is a skill that can be developed. The more you try to monitor changes in perception and understand emerging trends, the better you will become at it. In tracking trends it is useful to read widely what others are saying about shifting and emerging trends. As you develop a feel for the directional shifts in perception, then you should become more critical and focused in your analysis of what that means for your business and the new opportunities it may generate.

To effectively track trends you need to:

  • Look back. History can provide a glimpse into the future. By understanding past trends, technology developments and social changes, you will be better positioned to make assessments about the future.
  • Read and engage widely. Read across domains. If you only read and research in one area you are limited to one perspective. If you read in multiple areas you can develop a big picture mindset that will give you a much better idea of what is likely to occur in future. Pick up magazines that you would not otherwise browse through, search websites that you would not otherwise explore and listen to an alternative radio station at least once a week.
  • Record and share your thoughts. Write down the trends that you see changing. Build an argument for why you think they are shifting and share your thoughts with others. If you don’t write things down, your thinking will remain messy and unclear. If you don’t share your thoughts, your thinking will not develop and evolve as much as it could.

Take control, make it happen

This article has provided you with insight into the sources of new ideas and tools to take advantage of that insight. It is now up to you to use this knowledge and these tools to effectively make yourself and your business relevant for the future.

Greg Fisher, PhD, is an Assistant Professor in the Management & Entrepreneurship Department at the Kelley School of Business, Indiana University. He teaches courses on Strategy, Entrepreneurship, and Turnaround Management. He has a PhD in Strategy and Entrepreneurship from the Foster School of Business at the University of Washington in Seattle and an MBA from the Gordon Institute of Business Science (GIBS). He is also a visiting lecturer at GIBS.

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1 Comment

1 Comment

  1. Ms Katasi

    Dec 24, 2011 at 15:49

    Wow, fantastic article. I’ve just read Drucker’s Innovation and Entrepreneurship and must say you’ve brought out his points superbly. Thank you for the practical ideas too!

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How to Guides

What To Measure To Make Sure Your Business Won’t Crash And Burn

Let your customers measure success for you and you’ll have a better idea of how to reach your goals.

Harry Welby-Cooke

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If you don’t want your business’s spurts of success to end up just a flash in the pan, you need to measure your business progress against your goals. This allows you to adjust your plans for future success accordingly. But how?

Back in the nineties, NASA designed an interplanetary weather satellite to orbit Mars. However, it deviated from its planned trajectory and was destroyed in the atmosphere, simply because of a minor miscalculation; a result of the NASA team and their contractor using different systems of measurement.

By the same token, business owners need to determine what metrics to use to measure their progress, before they can work out what still needs to be adjusted to get them to their ultimate goals. Many businesses know this, but many don’t know they’re doing it wrong.

Connect with your customers

Most organisations use the same key performance indicators such as sales, customer retention, and product quality to track their progress. What’s the problem with this picture? They’re measuring where they are now in relation to where they were before, leaving the question of where they want to be, and how to close the gap, to guesswork.

Related: Good Customer Service Is About Relating At The Same Level

Why waste time testing one strategy after another when you can find all your answers in one place: With your current and prospective customers? They’ll tell you exactly where to aim and what to do to get there. This is why customer surveys are the proverbial toolkit of business progress tracking.

A customer survey is simply a series of questions that you ask your customers, to gauge their satisfaction, so you can hold on to them and collect ideas about how to improve your business offerings.

There are a number of ways to distribute these surveys, but it’s no surprise that social media is trumping phone calls, text messages and emails as the preferred platform for customers to communicate with businesses and brands.

Engage with your customers

What you choose to ask your customers is entirely dependent on what goals you wish to outline and track. That’s the easy part, but it’s significantly harder to gauge the effectiveness of social media campaigns, because you need to know what to look for. You can measure awareness of your business using metrics including volume, reach, exposure and amplification.

Retweets, comments and replies will tell you how engaging your content is, and you can keep an eye on traffic by tracking URL shares, clicks and conversions. Plus, there is a plethora of additional plug-ins to this from ORM and sentiment tracking tools for deeper analysis of this data.

Related: Does Your Customer Service Care?

The catch is that in the past, businesses had to compete for space — on billboards, in magazines, during ad breaks on TV — but now it’s all about timing. So the first challenge is making sure your social media post questions are being seen by as many of your customers as possible.

On the flip side of the coin, people don’t have to have any previous experience with your brand to interact with you on social media, so another challenge is calculating which of your respondents are actually viable customers.

Leverage your data

You’ll need to tap into the analytics that speak to who your followers are, and then focus on finding ways of channelling them on social media, based on their geographical location and the kind of content they are most likely to consume.

Then test your social media measurements against your key performance indicators. Yes, we’re back where we started, but this time you’ll be armed with what you need to leverage this data, in order to achieve your business goals.

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How to Guides

How Do I Go About Valuing My Business?

Francois Otto, Head of Corporate Finance and Jonathan Wernick, Corporate Finance Transactor, Sasfin Capital give advice on how to value a business.

Sasfin

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Francois Otto, Head of Corporate Finance and Jonathan Wernick, Corporate Finance Transactor, Sasfin Capital give advice on how to value a business.

If you have ever thought about raising capital for, or selling, your business? Perhaps one of the most difficult questions you have had to ask yourself is “How much can I sell my business for?” Regardless of what anyone tells you, determining the value of your business is a subjective process.

The value of business in one person’s hands can be completely different to another. However, there are a variety of methods to determine the value of a business. Some methods are fairly simple and others are a bit more complex.

Perhaps the simplest method that can used to value your business is to determine its Net Asset Value (“NAV”). This simple method entails subtracting the value of the liabilities from the value of the assets.

Related: Raising Capital Through A Black Economic Empowerment Transaction

Another method that can be used to value a business is to apply a specific multiple to a financial metric. This method is referred to as a comparative valuation or “MULTIPLES” approach. For example, a company’s net profit could be multiplied by a specific number to give you a value of the business.

The number which you multiply the earnings by is referred to as a “Price Earnings” or “PE” multiple. The size of this number will depend on the business in question, for example its growth prospects, its size and the industry in which it operates, just to name a few.

The final approach that can be used to value a business is the discounted cash flow (“DCF”) method. This method adopts the philosophy of “Cash is King”.

Under this method, the business is valued using cash flows that the business is expected to generate. Cash flows can take the form of future dividend payments or, if the business pays a small or even no dividend, cash flows can take the form of profits generated by the business after adjusting for future capex, investments in working capital and taxes payable.

As this method values a business using the cash flows it is expected to generate in the future, a discount needs to be applied to these future cash flows (to reflect the uncertainty thereof), the size of which increases the further out in the future the cash flow occurs. The aggregate value or sum of these discounted cash flows represents the estimated value of the business.

Related: Here’s How To Value Your Business

The three valuation methods (NAV, MULTIPLES or DCF) mentioned above can yield different values for a business and deciding which method to use will often depend on the purpose of the valuation as well as the specific business being valued.

This exercise is normally the first step in raising capital or selling your business, to provide the owners with a sense of value. This value is theoretical until such time as a willing investor agrees to a transaction.

This is where a good adviser will assist the owners, through effectively marketing their business, to optimise the value achieved by the owners with the added benefit of ensuring the terms of a transaction are fair to the owners (e.g. reasonable earn-out conditions and warranties).

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How to Guides

How You Can Use Your Creditors To Fund Your Business Growth

Everything you need to know to keep your cash flow positive, use your creditors to fund your business, and make your numbers work for you.

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The success of a business is often judged by its rate of growth and its number of employees. The problem is that both a business’s rate of growth and its size come with their own demands and consequences, which are often ignored in the pursuit of more and more growth.

The reality is that not all growth is created equal. If your business doesn’t have scale, you can end up growing yourself into trouble — or even out of business.

Even more important is positive cash flow. Is that great new contract bringing in money, or costing you money? Shouldering an upfront cost for growth down the line is all part of the growth journey, but only if the numbers make sense and you know when your investment will turn to profit.

Here’s the secret to growth: It can be self-funded. Yes, there are venture capitalists, private equity firms, angel investors, bank funding and a host of other ways to access finance — but you can grow a large, successful organisation without any of these.

The trick is to know your numbers. Here’s how you can practically apply the rules of positive cash flow to your business.

Related: 6 Ways To Make Your Business Look Big While You’re Still Growing It

The Power of Cash

In 2012, Amazon’s share price was $173. By 2016 this had grown to $725. Walmart, arguably the biggest retailer in the world, went from $59 to $70 in the same period.

But take a look at Table 1 for the revenue growth of both companies between 2003 and 2012 (a trend that has continued).

revenue-growth

How can Walmart’s stock price have hardly increased, while Amazon experienced impressive growth over the same period, despite the fact that Walmart’s revenue growth far outstrips Amazon’s (in absolute, not percentage terms)? Is Walmart’s stock undervalued, and Amazon’s overvalued? Even accounting for growth off a low base, how can we explain this?

The share price is simply the net present value of future free cash flows generated from the efficiency of an organisation in managing cash to generate more sales.

In other words, Jeff Bezos’ focus on his cash conversion cycle has meant his business is incredibly cash-positive, which has in turn positively impacted Amazon’s stock price. Although Amazon is a highly unusual business with its negative cash conversion cycle, and its actual liquidity is somewhat contested by the investment community, it’s a great example of getting customers to fund growth.

Related: Five Keys To Unlock Massive Leaps In Profit

The Cash Conversion Cycle

We agree that it takes money to make money. A business, even one with a tight, scalable business model, will consume more cash in its growth phase than in its steady state, or execution phase.

But, you don’t want to ever spend more money than you need to — or can reasonably afford to. This is true whether you’re self-funded or spending someone else’s cash, but particularly if you’re funding your own growth. Dealing with unplanned funding can be costly, time-consuming and it hampers growth. It also bogs you down in stressful admin when you could be focused on the elements you love and that excite you.

There are two questions that you should have asked yourself as you embarked on your growth journey (note: if you’ve never asked these questions, you need to surround yourself with like-minded business people who can help you find and ask them):

  1. For what period of time is my money tied up in inventory and other current assets before customers pay for the end product or services?
  2. How much cash do I need to finance each unit of sale and what is the amount of cash generated by each unit of sale?

I guarantee you that Jeff Bezos knows the answers to these two questions. Not his accountant or financial director — Jeff himself. You can’t abdicate the numbers of your business to someone else. Understand the difference between delegation and abdication. You don’t need to be doing your business numbers but you absolutely need to know what they are. This is one of the most important metrics of your business.

Let’s go back to our example of Amazon (see Table 2): Bezos’ cash conversion cycle (measured in days), oscillates between -40 and -8 days. That’s the secret.

In other words, Amazon uses other people’s money to fund its operations. That’s an extremely valuable business model, as its share price demonstrates.

Walmart’s cash conversion cycle is also a very respectable 11 days. As a business model it’s not quite as valuable as Amazon’s, but there’s a reason why Walmart is an international leader in its industry. It takes this behemoth organisation just 11 days to convert $1 into something worth more than $1. It then recycles that original $1 a further 35 times per year. Walmart’s margins are not high, but the compound growth is very powerful, as we’ll see later.

Let’s Get Started

starting-to-fund-a-business

Step 1: Understand your business

To better understand the components of your operating cash cycle and your cash conversion cycle, take a look at Diagram 1.

cash-conversion-cycle

Operating cash cycle (OCC) is the period of time between when you start the assembly of all the required inputs into your production line, and cash comes back into the business as payment for the sale. Remember, if you’re a B2B business, there’ll be a delay between when the customer starts using your product and service, and when payment is made as well. This difference is referred to as accounts receivable days. Likewise the time between when your production starts (having received inventory) and the moment your business pays for this inventory, is the accounts payable days.

Cash conversion cycle (CCC) This is the period of time that working capital is tied up. It’s the time between when cash was converted into one of the inputs for your production line, and when the product is converted back into tangible cash, handed to you when customers pay you in real money. It’s the difference in time between your operating cash cycle and account payable days.

Self-financing growth rate (SFG)

This is the crux of this article. Your SFG rate is the rate at which growth can be sustained by cash generated by your business without any external funding.

Related: Why The Climb To The Top Is The Most Critical For Your Growth

Step 2: Working out your cash conversion cycle

Where can you access the figures you need to determine your own OCC, CCC and SFG? First, use data spanning a 12-month time period. This has two advantages: You have a better chance of sourcing accurate data if it comes from a signed off financial statement, and you can dampen the noise caused by seasonality.

Work with your balance sheet and income statement.

Working out conversion days from balance sheet

Asset ZAR amount on (000) Equivalent days Liabilities ZAR amount on (000) Equivalent days
Cash 10   Accounts payable 99 Calc A
Accounts receivable 384 Cal B Loan

repayments

50  
Inventory 263 Calc C Current liabilities 149  
Current assets 657   Retained earnings 183

 

 
Plant & equipment 25   Capital contributed 350  
Total assets 682   Total liabilities 682  

 

Working out conversion days from income statement

IS line ZAR amount on (000) Day equivalent Ratio
Line ZAR amount on (000) Day equivalent in (000) Ratios in %
Revenue / Income 2 000 = 2 000/365 = 5 479 100
Cost of sales 1   200 = 1 200/365 = 3 288 60
Profit 800   40
Operating expenses 700 = 700/365 = 1 918 35
NPBT – net profit before tax 100   5

income-statement-valuation

Based on the above example and figures, we have determined the following information:

  • This business generates R5 479 of income per day at a cost of R3 288 per day.
  • Calculation A: We owe a total of R99 000 to our suppliers, which at
    R3 288 per day is ~ 30 days from
    99 000 / 3 288
  • Calculation B: We are owed R384 000 from our customers, which at
    R5 479 per day is ~70 days from 384 000 / 5 479
  • Calculation C: The amount of inventory we have paid for and need to turn into a sold product in equivalent days is ~ 80 days from 263 000 / 3 288.

Our original ‘as-is’ timing diagram now looks like this:

cash-cycle-advice

We still need to account for operating expenses, including salaries, utilities, rent, marketing costs and so on, and we can safely assume (but check this for your business) that bills arrive uniformly over the 150 day OCC period, meaning some will be paid immediately (day 1) or have to wait (day 150). On average this is 75 days.

You should now interpret the information as follows;

  • The OCC is 150 days, but because the business has 30 days to pay its suppliers, the CCC is 120 days. In other words, cash is tied up for 120 out of 150 days (80% of the time).
  • In terms of operating expenses, we assumed a uniform distribution over the period whereby some creditors would be paid immediately and some would have to wait for the 150-day cycle to finish. On average, this leaves us with 75 days or 50% of the OCC.

Related: Mobility, Security And Your Business

Step 3: Unlock capital in your business

We now know for how long our cash is tied up, but we still need to determine how much is tied up. Using the ratios in the original income statement, we can now answer the following: What amount of cash is needed to finance each unit of sale, and what is the amount of cash generated by each unit of sale?

Cash conversion at work on your IS

Income statement line Per ZAR with CCC factoring effective per ZAR
Revenue/Income 1,00    
Cost of sales 0,60 80% (120/150) 0,48
Operating expense 0,35 50% (75/150) 0,18
Total costs 0,95 Cash tied up per 1 ZAR of Sales Revenue 0,66
Profit before tax 0,05
Free cash generated per ZAR of Sales 0,05 Cash needed for each OCC 0,66

Putting it all together

Let’s look at what you now know about your business:

Self-funded growth rate

The cash generated from 1 ZAR of sales By looking at the income statement ratio 0.05
The time in days of your OCC Calculated from holdings inventory days + accounts rec days 80 + 70 w= 150
The CCC time to cycle cash used in the OCC Calculated from OCC – accounts payable days 150 — 30 = 120
The cash tied up in each OCC for a 1 ZAR sales income Restated IS with CCC factored in for OpEx and inventory 0,18 + 0,48 = 0,66
Your per cycle growth rate Free cash that can be added to the OCC cash requirement 0,05 of 0,66 -7,57%
How many cycles can be completed in a year? Days in year available divided by OCC 365/150 = 2,43
Assume a productivity factor for safety 90% as a reasonable contingency for strikes etc 2,43 x 0.9 = 2,19
Compounded annual self-funded growth rate (1 + SFG) OCC cycles – 1) = (1 + 0,0757) 2.19 – 1 = 17,3%

Driving growth in your business

So, how can you use this information to drive growth in your business?

First, your debtors book must exceed your creditors book. Then, if we just shorten our accounts receivable days from 70 to 30 days, the following would happen:

  1. The OCC is now 150 — 40 = 110 days
  2. CCC is 110 — 30 = 80 days
  3. Cash needed for cost of sales is 0,60 X 80/110 = 43 cents
  4. We have not targeted operating costs yet, which remain at 18 cents
  5. Round everything up and we now need 62 cents instead of 66 cents (6% improvement)
  6. Your per cycle growth rate is 5 cents/62 cents = 8% growth rate
  7. How many cycles can you do in a year now? 365/110 = 3,3 cycles; up from 2,43!
  8. This is a 36% improvement
  9. Add a contingency of 95%, which gives us 3,13 cycles
  10. Compound this over a year: (1+ SFG) nbr of cycles — 1) = (1 +0,08) 3,1 -1) = 26% from 17% originally.

That’s 9% growth and nobody noticed a thing!

Related: Jason Goldberg Asks Are You (Realistically) Ready To Scale Your Business?


Key takeaways

  • That large corporate account that you cherish and that one of your sales executives is overly proud of landing may well be destroying value in your business. Why? Because large corporate accounts tend to get over-serviced (and I doubt you allocate those costs properly) and tend to pay you late.
  • Growing with a greater number of smaller customers, steadily over time, within your means and without being bullied delivers more value and less stress.
  • There are easy and clever ways to add lots of value to your business, that cost very little to implement, but you do require an understanding of how cash gets tied up.
  • Delegate, don’t abdicate. No entrepreneur is ever great at sales, production, operations and cash management, so get people who can complement your skill set, and allow you to do what you enjoy. That said, you can never hand the numbers over to someone else. Receive assistance if you need it, but know your numbers!

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