Business growth: grow sustainably or go bankrupt

Growth and growth management present special problems in financial planning. Growth is not always a blessing. Many companies find themselves in financial distress, have cash flow problems, or even go bankrupt while they have full order books. There may be several causes for this phenomenon. However, one of the main causes is the fact that companies grow too fast for their strategic financial resources to support them.

Higher turnover implies higher assets in the form of inventories, debtors and fixed assets. To achieve a sustainable growth rate, these assets must be financed through financial resources generated by a company or accessible to a company. The greatest limitation, therefore, of sustainable growth is the ability to generate sufficient capital to finance the increase in assets (increase in working capital needs). Nonfinancial resources that also need to grow sustainably include a company’s systems, as well as the skills and experience of its employees.

Importance of growth

Growth is essential for the survival of a company. Strategically, a company needs to grow to increase its market share and gain a competitive advantage over its competitors. Other important benefits of growth are a company’s assets that can be used more optimally, economies of scale that occur, and profitability that can be increased. In the final analysis, growth is extremely important to optimally position a company for harvesting purposes.

Determinants of sustainable growth

Sustainable growth depends on the rate at which a company can generate funds and use these funds effectively. The maximum rate at which a company can increase its sales without depleting its financial resources is called the sustainable growth rate. The main determinants of sustainable growth are the rate of return, financial leverage, dividend policy, and external equity.

• Rate of return – The rate of return a business achieves forms the basis for how fast the business can grow. A company’s profit margin (after taxes) multiplied by asset turnover (sales divided by total assets) gives the company’s rate of return or return on assets (ROA).
• Financial appeceament – A company often uses debt to take advantage of a constant rate of return (ROA) to achieve a much higher return on equity (ROE).
• Dividend Policy – A company’s dividend policy is a critical variable in manipulating the rate of sustainable growth. A 50% dividend payment allows a company to grow only half as fast as a similar company with no dividend payment.
• Foreign Heritage – Outside capital is the most expensive form of growth financing and dilutes shareholder returns. Outside capital should only be used as a last resort to finance a business.

An example of sustainable growth.

There are several formulas of sustainable growth rate. Some of them go into great detail and take into account inflation, interest rates, external equity, and various components of a business. A basic formula (formulated by Hewlett-Packard) that is very useful is:

SGR = SWR*r

where:

SGR = sustainable growth rate

r = retention ratio (1 – dividend payout ratio)

ROE = net profit margin * asset turnover * equity multiplier

The above formula takes into account a company’s rate of return, financial leverage, and dividend policy. It is based on the following premises:

• It is not practical (or possible) to issue more shares (diluted equity).
• The company is managed effectively and profit margin and asset turnover are at optimum levels.
• Dividend payout is at the minimum level to keep shareholders comfortable.
• The debt/equity level is at an optimal level considering the company’s risk profile.

If we take a company with the following performance indicators:

• Turnover (sales) – $100 million
• Net income (after taxes) – $8 million
• Equity – $20 million
• Total assets – $50 million
• Payment of dividends – 0.4 (40%).

Therefore:

• Net profit margin = 8/100 = 8%
• Asset turnover = 100/50 = 2
• Financial leverage = 50/20 = 2.5
• Retention ratio = 1 – 0.4 = 0.6

The sustainable growth rate is:

SGR = SWR*r

= (8%*2*2.5*0.6)

= 24%

It means that if this company uses all its internal financial resources effectively, it can increase its sales to a maximum of 24%. The turnover of the company can thus increase from $100 million to $124 million. If the company grows more than 24% with its current parameters, it is actually creating cash flow problems and this can eventually lead to bankruptcy.

How can a company grow faster?

If a company wants to grow faster than its sustainable growth rate indicates and does not want to dilute its capital, it needs to generate more finance through one or more of the following:

• Increased profitability: This can be achieved through various factors, such as higher gross margins and lower expenses.
• Better Asset Management – ​​This can be achieved by creating more sales and profits relative to assets and by lowering stock levels and days outstanding.
• A higher retention rate: the majority of profits are reinvested in the business.
• A higher debt ratio: the expansion of assets is financed mainly with debt.

Summary

Growth is extremely important for any company to survive, gain market share, gain a competitive advantage, and position itself for the harvest. However, uncontrollable growth is just as damaging as very low growth and can put significant pressure on a company’s cash flow and can even lead to bankruptcy.

However, the management of a company can scientifically analyze the optimal rate of sustainable growth of the company with the use of ratios and financial models. The sustainable growth rate of a company can be increased if its determinants can be managed more effectively.

Sustainable growth must be an integral part of any company’s strategy and must be managed professionally.

Copyright © 2008 by Wim Venter. ALL RIGHTS RESERVED.