Business Growth – Grow sustainably or go bankrupt

Growth and growth management pose particular problems in financial planning. Growth is not always a blessing. Many companies are in financial distress, have liquidity problems or even go bankrupt while their order books are full. This phenomenon can have several causes. However, one of the main causes is the fact that companies are growing too fast for their strategic financial resources to support.

Higher sales implies higher wealth in the form of inventories, accounts receivable, and fixed assets. In order to achieve a sustainable rate of growth, these assets must be funded by funds that a company generates or has access to. The greatest constraint to sustained growth is therefore the ability to generate sufficient capital to fund asset growth (increase in working capital needs). Non-financial resources that also need to grow sustainably include a company’s systems and the skills and experience of its employees.

importance of growth

Growth is vital for a company to survive. Strategically, a company needs to grow in order to increase its market share and gain a competitive advantage over its competitors. Other important benefits of growth include a company’s wealth that can be used more effectively, economies of scale that occur, and profitability that can be increased. Ultimately, growth is extremely important in order to optimally position a company for harvesting purposes.

Determinants of Sustainable Growth

Sustainable growth depends on how quickly a company can generate funds and use those 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 most important determinants of sustainable growth are yield, leverage, dividend policy and external equity.

  • yield – The rate of return that a company generates forms the basis of how quickly the company can grow. A company’s profit margin (after tax) multiplied by asset turnover (sales divided by total assets) gives the company’s rate of return, or return on assets (ROA).
  • Leverage – A company often uses leverage to leverage a constant rate of return (ROA) to achieve a much higher return on equity (ROE).
  • Dividend Policy – A company’s dividend policy is a key variable in influencing its sustainable growth rate. A 50% dividend payout lets a company grow at half the rate of a comparable non-dividend-paying company.
  • External equity – Debt is the most expensive form of growth financing and dilutes shareholder returns. Borrowed capital should only be used as a last resort to finance a company.

An example of sustainable growth.

There are different formulas for sustainable growth rates. Some of them analyze in great detail, taking into account inflation, interest rates, external equity, and various components of a company. A basic formula (formulated by Hewlett-Packard) that is very helpful is:

SGR = ROE*r

Where:

SGR = sustainable growth rate

r = retention ratio (1 – dividend payout ratio)

ROE = Net Profit Margin * Asset Turnover * Equity Multiplier

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

  • It is not practical (or possible) to issue more shares (dilution of equity).
  • The company is run effectively and profit margins and asset turnover are at optimal levels.
  • The dividend payout is at the minimum level to reassure shareholders. Let’s take a company with the following key performance indicators:
  • Leverage is at an optimal level considering the company’s risk profile.

Let’s take a company with the following performance indicators:

  • Revenue (sales) – $100 million
  • Net Income (After Tax) – $8 million
  • Equity – $20 million
  • Total assets – $50 million
  • Dividend payout – 0.4 (40%).

Because of this:

  • Net 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 = ROE*r

= (8%*2*2.5*0.6)

= 24%

This means that if this company uses all of its internal financial resources effectively, it could increase its revenue by a maximum of 24%. The company’s turnover can thus increase from 100 million to 124 million US dollars. If the company grows faster than 24% with its current parameters, it actually causes liquidity 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 equity, it needs to generate more finance through one or more of the following:

  • Higher profitability – this can be achieved through several 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 reducing inventory and days sales.
  • A higher retention rate – most of the profits are reinvested in the business.
  • A Higher Debt Ratio – Wealth growth is funded primarily by debt.

summary

Growth is extremely important for any business to survive, gain market share, gain a competitive edge, and position for harvest. However, uncontrollable growth is just as damaging as very low growth and can seriously strain a company’s liquidity and even lead to bankruptcy.

However, a company’s management can use financial ratios and models to scientifically analyze the company’s optimal sustainable growth rate. A company’s sustainable growth rate can be increased if its determinants can be better controlled.

Sustainable growth should be an integral part of every company’s strategy and managed professionally.

Copyright© 2008 by Wim Venter. ALL RIGHTS RESERVED.