Growth is central to human nature. The same principle applies to companies. A slowdown in growth often signals problems in a company and, if irreversible, can mean the company’s demise. Entrepreneurs are highly growth oriented and typically actively strive to achieve maximum growth and capture as much market share as possible. If not properly managed, this growth can be counterproductive and financially damage or even ruin a company.
For more than a decade, Ventex Corporation observed and advised on the growth patterns of several companies. This case study focuses on two manufacturing companies in the same industry. Details are changed for confidential purposes – however all details simulate the real world scenarios close enough to demonstrate actual insights. The following highlights the metrics of the two companies over a five-year period:
- Company A’s revenue increased from $78.9 million to $348.7 million. Company B’s sales were better controlled, increasing from $77.5 million to $178.9 million.
- Company A’s profit margins (net profit divided by sales) fell to 1.2% from a low 2.5%. Company B’s profit margin increased from 4.1% to 16.8% over the same period.
- Asset turnover (sales divided by total assets) for both companies has remained reasonably stable over time. The average was 2.3 for Company A and 1.9 for Company B.
- The financial leverage (debt plus equity divided by equity) for Company A was 19.1 in year one and decreased to 12.3 in year five. In comparison, Company B had a financial leverage of 3.0 in year one and down to 1.6 in year five.
- Company A returned all profits to the business except for the third year when the retention rate was 74%. Entity B had a 100% retention rate for the entire period.
- Sustainable growth numbers showed that by year five Company A could grow to a maximum of $301.7 million (they grew to $348.7 million) and Company B to $184.3 million (they grew to $178 $.9 million).
Both companies were analyzed in detail. One of the key insights came from using the basic formula for sustainable growth rates (SGR) formulated by Hewlett-Packard:
SGR = ROE*r Where:
SGR = sustainable growth rate
r = retention ratio (1 – dividend payout ratio)
ROE = Net Profit Margin * Asset Turnover * Equity Multiplier (financial leverage)
The sustainable growth rate is based on the figures for the previous year. In the event of a deficit (actual sales are greater than target sales according to the formula for sustainable growth) over a longer period of time, there is a very good chance that a company will get into financial difficulties or even go bankrupt. This is exactly what is happening with Company A. In contrast, Company B grew below its sustainable growth rate and kept its financial position intact, becoming a very strong player in its industry.
What were the differences between these companies? Both companies started with similar sales ($78.8 million vs. $77.5 million). When analyzing the companies, four important differences stand out:
- Company A has a much lower profit margin than Company B (1.4% annualized versus 10.4%). Company B’s profitability has actually increased over time. Further analysis showed that Company A lowered prices and quite often made unprofitable deals to gain market share. Their gross profit margins averaged under 20% compared to more than 30% at Company B. Company B often abandoned bad deals and focused on selling their products based on their value-added services.
- Company A funded its growth with extremely high levels of debt compared to Company B (11.3x annual average financial leverage versus 2.2x). A more in-depth analysis of Company A found that the initial financial leverage ratio of 19.1 was unsustainable and the company then sold equity to fund growth and reduce the debt ratio. This proved to be insufficient and eventually the high level of debt hit them again. In contrast, Company B used less leverage and almost halved its financial leverage over the period. Today they are extremely liquid and contain solvents.
- Company A paid a dividend of 26% in its third year. This made a crucial difference at this stage. Further analysis showed that they could actually have a surplus (actual sales minus target sales using the sustainable growth rate) of $3.3 million in year four instead of a deficit of $7.8 million. Company B reinvested all of its profits back into the company and they later reaped the profits. Indeed, further analysis revealed that their expenses (including salaries to directors/shareholders) were much lower relative to Company A’s.
- Ultimately, Company A consistently grew faster than it could afford. In the fifth year, they had sales of $348.7 million, resulting in a deficit of $47 million. They couldn’t fund this additional deficit and it led to their ultimate downfall. By comparison, Company B grew to $178.9 million by year five — $5.4 million below its targeted revenue based on its sustained growth rate. The company could easily afford this growth.
A detailed analysis revealed many other differences between the two companies. Company A’s strategy proved to be one of uncontrollable growth, lack of financial discipline, unnecessary risk, premature profit-taking and a lack of focus. The company was eventually liquidated.
On the other hand, Company B opted for a strategy of controllable and sustainable growth, strict financial discipline, limited risk and focus on profitable business. Today, the company is recognized as a leader in its sector and its harvesting potential is excellent, as many international players have already expressed great interest in acquiring the company.