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 straits, have cash flow problems, or even go bankrupt while having full order books. There can be several causes for this phenomenon. However, one of the main causes is the fact that companies are growing too fast for their strategic financial resources to support them.

A higher turnover implies higher assets in the form of shares, debtors and fixed assets. To achieve a sustainable growth rate, these assets must be financed through financial resources that a company generates or that a company can access. Therefore, the greatest limitation to sustainable growth is the ability to generate sufficient capital to finance the increase in assets (working capital needs increase). Non-financial 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 achieve a competitive advantage over its competitors. Other important benefits of growth are the assets of a company that can be used more optimally, the economies of scale that occur, and the profitability that can be increased. In the final analysis, growth is extremely important to optimally position a company for harvest purposes.

Determinants of sustainable growth

Sustainable growth depends on the rate at which a business 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 is the basis for how quickly the business 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).
  • Financial appeceament – A business often uses debt to take advantage of a constant rate of return (ROA) to achieve a much higher return on equity (ROE).
  • Dividend Policy – The dividend policy of a company is a critical variable in manipulating the sustainable growth rate. A 50% dividend payment for a company to grow only half as fast as a similar company without dividends being paid.
  • External equity – External capital is the most expensive form of growth financing and dilutes shareholder returns. External capital should only be used as a last resort to finance a business.

An example of sustainable growth.

There are several sustainable growth rate formulas. Some of them go into many details 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 = ROE * r

where:

SGR = sustainable growth rate

r = retention ratio (1 – dividend payment ratio)

ROE = net profit margin * asset turnover * capital multiplication

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

  • It is not practical (nor possible) to issue more shares (diluted capital).
  • The company is managed efficiently and the profit margin and asset turnover are at optimal levels.
  • Dividend payment is at the minimum level to keep shareholders at ease.
  • The level of debt / equity is at an optimal level considering the risk profile of the company.

If we take a company with the following performance indicators:

  • Turnover (sales) – $ 100 million
  • Net profit (after taxes) – $ 8 million
  • Equity – $ 20 million
  • Total assets – $ 50 million
  • Dividend payment – 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 = ROE * 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%. Therefore, the company’s turnover can increase from $ 100 million to $ 124 million. If the company grows faster than 24% at its current parameters, it is actually creating cash flow problems and this can ultimately 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 finances through one or more of the following:

  • Higher profitability – This can be achieved through a number of 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 decreasing inventory levels and days of debtors.
  • A higher retention rate – Most of the earnings are reinvested in the business.
  • A higher debt ratio – Asset expansion is financed primarily by debt.

Summary

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

However, the management of a company can scientifically analyze the optimal sustainable growth rate 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 should be an integral part of any business strategy and should be professionally managed.

Copyright © 2008 by Wim Venter. ALL RIGHTS RESERVED.

Leave a Reply

Your email address will not be published. Required fields are marked *