Just like the circle of life, businesses too are born, they grow and develop, reach maturity, they begin to decline, and finally (in many cases) they age and die. The life cycle shows the business’ progression in phases over time, which may impact its numbers. Let’s find out by understanding the business cycle.
Pilot stage: An idea is born, maybe to launch a new product or service. For instance, if one starts up a tiffin delivery service, the initial stage’s low demand visibility gives the business an added advantage of only incurring variable costs of vegetables, other ingredients. The absence of any fixed costs (FC) gives the business the ability to deliver all-time high gross profit (GP) and net profit (NP), profit margins and even the return on investment stands at the highest ever levels! Sadly, this doesn’t last very long!
Startup: This is where the conversion of a great business idea into a commercially viable product/service happens. But it also brings along with it enormous investments in fixed assets (FA) to cater to the projected growing demand in the coming years. Say industrial-grade cooking appliances for the tiffin business. Regrettably, 95% of businesses fail in this stage itself since they are unable to truly project the demand, FC and FA investments from the not-so-ever-lasting euphoric pilot stage! To gain distributor’s trust, credit sales are key! This in turn shoots up the cash conversion cycle (CCC), which only lowers once the business enters the successive phases. Due to high credit sales, low purchasing power and working capital needs to run daily operations, young businesses expect to see negative operating cash flows (OCF) during the initial stages. With growing investments in FA (low base but fast-growing) coupled with little revenues (increasing slow and steadily), the business’ asset turnover ratio (AT) and return on invested capital (ROIC) stands at its lowest here; again, gradually increasing in the coming stages.
High growth: Here, businesses will see extremely high revenue growth with some even managing to double their revenues (y-o-y) solely due to the initial stage’s extremely low base. However, GP and NP still remains high; albeit not as much as in the previous stages. CCC also remains high, but is comparatively lowering as credit is still king! With rapid sales growth and stabilized expenses, finally, there’s a chance for OCF to turn positive. As revenues are still unable to catch up with the growing asset base, AT and ROIC may remain low.
Slow growth: As these companies begin ageing, revenue growth tends to slow down since they are now building off of a bigger base of the early phases. In fact, given the humongous base from which it grows, even lower growth in sales is much more impressive now. Nevertheless, sales are at their peak level and ROIC is high. Profits may still grow but now at a much slower pace. OCF increases and manages to even exceed profits; making it the best time to invest in such proven businesses that have stood their ground in the face of aggressive competition and market saturation. Reputed businesses can even enjoy bargaining power from both, supplier and customer, further reducing CCC.
Maturity: As a company enters maturity, its revenues barely change from one year to the other. Here, GP will stagnate and NP will go down even further as diseconomies of scale set in. Business may not invest in themselves as much as they used to and as major capital spending isn’t a concern they may enjoy the highest-ever AT and ROIC. With negotiating power, now cash becomes king and so, CCC is at an all-time low. As per management’s decisions, companies can choose to pay large dividends, buyback stock often funded with debt pushing towards a high D/E ratio. In any case, if one’s business investment is approaching the maturity cycle’s end or about to enter the decline stage, it’s best to take your money and exit since what’s about to come next may just be a big disappointment!
Decline: In the final stage, revenues will shrink and cash flows too drop off since the business makes fewer profits. This is where one starts harvesting the business, dividend policy kicks in. Companies lose their competitive advantage, either accept their failure and call it quits or move onto other money-making avenues, thus extending the lifecycle. The business lifecycle busts myths of “safe large-cap, risky small-caps". What’s far more important is being able to make a judgment as to where a company (regardless of capitalization) stands in the lifecycle.
Koushik Mohan is the fund manager of Moat Financial Services.
