Beware the flat spot: if your business enjoys a prolonged period of rapid growth, it can take a frustratingly long time for the accounts to reflect it positively. David Allen advises on how to approach such a situation. (Management).

One of the more obvious consequences of the rapid rate of evolution characterising today's business environment is the extent of structural change occurring in the economy. Understandably, in view of the human costs involved, media coverage is heavily biased towards those enterprises that are in decline.

This is a manifestation of the "principle of exceptions"--that is, there is no point in wasting time on things that are going well; focus on the problems. Such an approach seemed to make sense in a stable environment, because an unsolved problem would always recur. But in now it is a recipe for failing to spot opportunities. I would therefore like to redress the balance by looking at the matter of growth and, in particular, its relationship with profitability.

In an earlier article for this column I pointed out that the higher the rate of return you seek, the lower your rate of growth will be, because at the margins you will be turning away business that your competitors are happy to accept. Moreover, if the rate of return you seek is greater than the cost of capital, you will inevitably fail to maximise the net present value of the business--in a way that will never be quantified or reported.

But there is another angle that is worth noting: the recognition that the higher the rate of growth you are experiencing, the lower the accounting rate of return (the ratio of profits to assets used) you will show. I was reminded of this recently in the context of a business in which I am involved, and which is enjoying its second successive year of 25 per cent growth.

The causes of a decline in the return on assets can be summarised as follows:

* Timing. The investment in tangible assets--notably plant and stock--precedes the benefit in the form of increased output. This is accentuated by the accounting concept that requires investments in activities such as R&D, marketing and training (all of which are made in anticipation of increased volume) to be treated as costs rather than assets.

* Stepping. The investment in assets, be they tangible or intangible, will be immediate, but the volume will normally build over time. The same applies to most so-called fixed costs, and again the situation will be accentuated by "one-off" items such as recruitment.

* Learning. Productivity will be affected when there is a lack of know-how, which often occurs where there is an influx of new recruits. This will show up in the form of material wastage and labour and machine inefficiencies--eg, standard hours per clock hour--as operators get to grips with the demands of new customers and the features of new materials and processes.

The experience is analogous to the "flat spot" in a car's acceleration: you put your foot down, but for a while the dashboard shows no measurable increase. And so it is with business growth: you put your foot down, but for a while your accounting ratios will not improve. In fact, they will deteriorate.

So what is the role of the financial manager in this environment? As in so many other situations, I find the "three As" provide a stimulating framework:

* Awareness. You need to be mindful of the inverse relationship outlined above, and to make your colleagues aware of it too. This should not be too hard if you have already explained to them the limitations of the accounting model as a basis for the making and the monitoring of decisions. You will need to ensure that exceptional costs and so on are recognised as such. Suggestions that the adverse variances imply that the standards are wrong and need to be eased, or that the quality of the product will have to be compromised, must be countered. Such costs are the short-term price that's paid for long-term benefits in the form of competitive advantage.

* Anticipation. The use of a financial model, linked to rolling budgets, will help you to tell the extent of the temporary dip in the ratios. This should be followed through to show the effect on cash flow--the higher the rate of growth, the lower the current level of cash generation. Indeed, if the rate of growth exceeds the rate of return, a cash absorption is the likely result.

* Adaptation. A time of rapid growth offers a chance to improve the product mix--for example, by increasing margins on less profitable business. Either profit will improve or the growth pressures will be eased. But it is also a time when your investment appraisal skills will be in great demand. The question will not be "does this investment show a positive net present value?", but "does this investment contribute to maximising the business's net present value?"

The focal point will be a forecast of cash flows in a form designed to make the case for an appropriate amount of new funding, whether this be from owners or lenders, and to provide a basis for monitoring subsequent achievements.

As regular readers will know, I see this emphasis on looking forward as the defining characteristic of our branch of the profession. In my experience, providers of finance seem to be so impressed by what I have always seen as orthodox management accountancy that it makes me wonder whether they see it very often.

Am I alone in fearing that, as an institute, we are in danger of losing our distinctiveness?

David Allen CBE, a past president of CIMA, is a director of a number of private companies and an adviser on strategic financial management