You may be thinking, "Hey, business is good and should not slow down for a while. Maybe we should double the size of the place." Is this a good idea? Maybe yes, and maybe no.
I once prepared a seminar entitled "How to Sell Yourself Into Bankruptcy", and believe me, many of the business bankruptcies you hear about are related to uncontrolled expansion. The point is, expansion is good in most cases as long as you keep it under control and plan your cash flow. Just keep pushing sales and you are asking for big problems.
Expand with care
Many people believe that chasing the almighty sale is the way to profitability. That may be true when you're first starting out because you have made an investment and have fixed expenses to cover. You have to generate sufficient sales to produce enough profit to cover both your fixed and variable expenses.
Once established, you have to be more careful about uncontrolled expansion. The main goal is to maximize cash flow. Nothing else really matters.
And it is entirely possible to use up all your cash flow by expanding beyond your means.
Every dollar of sales requires some amount of working capital. This working capital is required because the spread between your current assets and liabilities increases with increased sales. In short, you always have to pay your bills faster than you can collect money for your work and products. Thus, as you increase sales, this need soaks up your existing cash and existing borrowing power, causing you to delay paying bills and eventually putting you into potential bankruptcy. So don't forget about this working capital need when planning expansion.
Expansion can also produce increased fixed costs, especially related to additional facilities or equipment obligations. Once you increase fixed costs, the base level of gross profit required to break even goes up along with the potential working capital requirement. In other words, the work better be there and not just for the next few months.
One of the reasons equipment rental is becoming more acceptable is because it allows a contractor to take on additional work without any related long-term equipment obligations. You put off any increase in fixed obligations until you're sure a higher sales level will stick. But no matter what, it is always good to avoid fixed obligations.
Measure free cash flow
Keeping in mind that profits equal free cash flow (cash flow that you can put in your personal cash account), I guess the trick to making a decision about expansion is to measure free cash flow before and after the change. Are you actually going to generate more free cash flow or not?
If you are questioning what "free cash flow" is, this is the cash flow you have remaining from your operations after you cover all of your fixed obligations including debt service. You measure cash flow from operations by taking your net income and adding back non-cash charges. If you subtract your principal payments from this cash flow number, you have the approximate "free cash flow".
To keep you on the right track, you should plan out your expansion by preparing budgets that include an income statement, balance sheet and cash flow analysis. Estimate a business increase of 20%, then estimate what changes you will have to make to handle this new business. What does the cash flow statement tell you now? Will you need more cash in the business? Where will it come from?
The increased working capital requirements, along with new fixed cost requirements, get covered from primarily three sources:
1. cash flow from existing profits
2. the bank
3. your personal savings account
Notice these are presented in order of preference. And notice that you can run out of all three pretty quickly.
You are only going to generate so much from current work. You can only borrow so much from the bank. You only have so much to invest. Run out of all three and you are out of business. Imagine taking on a job beyond your financial means and this is what can happen.