When an entrepreneur starts a business, there is usually one product/service in mind. They are focused on marketing and distribution. As they grow, they begin to think about diversifying the business mix. But whether your business sells Real Estate, Insurance or widgets, the primary reasons for diversification are to reduce risk, stabilize cash flow, and preserve a competitive advantage. Through diversification, you can
-Ensure sales during seasons when the demand for your primary product is low. In this situation, a firm should sell a related product that is active during business lulls, i.e. firm sells heating systems, as well as air cooling systems;
-Satisfy customer demands for related products. One mistake in business is to refer your client to a competitor, to satisfy a need which you cannot fill. More than likely, once they go, they will never come back. One stop shopping for customers is always preferable over visiting multiple vendors;
-Assume control of a supply or distribution chain, i.e. Amazon begins Sunday deliveries, to increase customer satisfaction;
-Stay competitive by exploring growth opportunities, i.e. develop new markets and/or attract new customers; and,
-Balance a business which has long periods between sales with a quick sales cycle, i.e. automotive sales which may occur every five years, offering auto service which occurs every six months.
From a purely finance perspective, when investing capital to achieve growth, only commit capital to those projects that meet your profit expectations, return on investment requirements and results in a positive free cash flow position.
–Profit – Funds available after total expenses are deducted from total revenues. The basis from which taxes are calculated. Pre-tax profits can be calculated monthly, quarterly, annually. This value is ideal to plan annually.
-Return on Investments (ROI) – Ratio of Income generated over dollars invested in a process or product financed, to stimulate the growth of the company. ROI is usually tracked for three to five years. This statistic should be used to ensure that financial resources are being allocated to growth opportunities with the highest returns.
-Free Cash Flow (FCF) – Funds available after paying expenses, adjusted for non-cash items, minus capital expenditures to maintain the firm’s current productive capacity, i.e. the amount available for distributions or future growth prospects. FCF is an annual measure.
A company that incorporates a diversification strategy should be prepared to also at times consider a divestment approach. Periodically every business should review its product lines and services, to understand the profitability generated. The natural result will be an emphasis on the most profitable activities; while de-emphasizing the less profitable or money loosing activities. Through this exercise, you will quickly identify problems in products and service fulfillment.
When you discover a line or business that is not performing as planned, there will be three questions that need to be asked – Is the business inefficient, but can be optimized? Is the business being managed by the correct person? Is the activity important to the overall strategy of your business?
If this line or business is not critical to your strategy, it may be time to divest.
It is not uncommon to read the press and see an article about a company divesting of a subsidiary. The next day, there is another press article that the same company is acquiring an entity. There are multiple reasons why a business may divest itself of a product line or subsidiary – the business does not meet expectations of profits, return on investment, or free cash flow targets. These success targets may have been missed due to faulty production assumptions in the planning of the new line or subsidiary; or external factors may make the business no longer profitable. Common external factors include unexpected regulation or taxes that make the business more expensive than previously planned; or a new competitor enters the market with a lower cost of doing business.
But the greatest reason for divesting an unsuccessful line or business is to free capital, so it may be allocated to more profitable activities.
When was the last time your business mix was reviewed?