Understanding the different stages of the business life cycle

pilot stage: An idea is born, perhaps to launch a new product or service. For example, if one starts a tiffin delivery service, the low demand visibility of the early stage gives the business the added advantage of only variable costs of vegetables, other ingredients. The absence of any fixed cost (FC) gives the business the ability to deliver an all-time high Gross Profit (GP) and Net Profit (NP), profit margin and even return on investment which is at all-time highs! Unfortunately, it doesn’t last very long!

start up: This is where a great business idea is converted into a commercially viable product/service. But it also brings with it huge investments in fixed assets (FA) to meet the anticipated growing demand in the coming years. Say industrial-grade cooking equipment for tiffin business. Sadly, 95% of businesses fail at this stage itself because they are unable to actually project demand, FC and FA investments from the never-ending enthusiastic pilot phase! To gain distributor’s trust, credit sales are important! This in turn prolongs the cash conversion cycle (CCC), which decreases only after the business enters successive stages. Due to high debt sales, low purchasing power and working capital required to run daily operations, young businesses expect to see negative operating cash flow (OCF) during the initial stages. The asset turnover ratio (AT) and return on invested capital (ROIC) of the business is lowest here, with low revenue (slow and fast growing) with increasing investment in FA (low base but fast growing) ; Again, gradually increasing in the coming phases.

high growth: Here, businesses will see extremely high revenue growth, with some even managing to double their revenue (y-o-y) only due to the extremely low base of the initial stage. However, GP and NP still remain high; Although not as much as in the previous stages. CCC also remains high but is getting comparatively low as credit is still king! With rapid sales growth and stagnant expenses, there is, finally, a chance for OCF to be positive. Since revenue is still unable to capture the growing asset base, AT and ROIC may remain low.

slow growth: As these companies begin to age, revenue growth slows because they are now building a large base of early stages. In fact, with the vast base from which it grows, even less sales growth is even more impressive now. Still, sales are at their peak and ROIC is high. Profits may still increase but now at a much slower pace. OCF grows and manages to exceed profits; This is the best time to invest in proven businesses that have stood their ground in the face of aggressive competition and market saturation. Reputable businesses can enjoy bargaining power from both the supplier and the customer, further reducing the CCC.

Maturity: As a company enters maturity, its revenue hardly changes from one year to the next. Here, GP will stabilize and NP will go down even more as scale discrepancies set in. The business may not invest in itself as much as they used to and while major capital expenditure is not a concern, they can enjoy the highest ever AT and ROIC. With the power of negotiating, now cash has become king and hence, CCC is at an all-time low. In accordance with management’s decisions, companies may choose to pay larger dividends, with buyback stock often funded with debt pushing toward a higher D/E ratio. In any case, if one’s business is approaching the end of the investment maturity cycle or is about to enter a downward phase, it is best to take your money and exit as what lies ahead could be a major disappointment. Is!

Downfall: In the final stage, revenue will decrease and cash flow will also decrease as the business makes less profit. This is where a business begins harvesting, the dividend policy begins. Companies lose their competitive advantage, either accepting their failure and giving up on it or moving on to other money-making avenues, thus extending the life cycle. Business lifecycle busts the myths of “safe large-cap, risky small-cap”. It is far more important to be able to decide where a company stands (regardless of capitalization) in the lifecycle.

Kaushik Mohan is the fund manager of Mott Financial Services.