Fixed Debt-Equity Ratio It Can Raise The Additional Funds By Business Growth – Grow Sustainably Or Go Bankrupt

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Business Growth – Grow Sustainably Or Go Bankrupt

Growth and the management of growth present special problems in financial planning. Growth is not always a blessing. Many companies are in a financial predicament, have cash flow problems or even go bankrupt while they have full order books. There can be several causes for this phenomenon. One of the major causes, however, is the fact that companies grow too fast for their strategic financial resources to support them.

A higher turnover implicates higher assets in the form of stock, debtors and fixed assets. To achieve a sustainable growth rate these assets need to be financed through financial resources that is generated by a company or that can be accessed by a company. The biggest constraint, therefore, of 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 to achieve a competitive edge against 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 increase. In the final analysis growth is extremely important to optimally position a company for harvesting purposes.

Determinants of Sustainable Growth

Sustainable growth is dependent on the rate that a company can generate funds and utilise 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 major determinants of sustainable growth are rate of return, financial leverage, dividend policy and external equity.

  • Rate of Return – The rate of return that a company achieves forms the basis of how fast the company can grow. The profit margin of a company (after tax) multiplied by the asset turnover (sales divided by total assets) gives the rate of return or return on assets (ROA) of the company.
  • Financial Leverage – A company often uses debt to leverage 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 dividend payout of 50% allows a company to only grow half as fast as a similar company with no dividends being paid out.
  • External Equity – External equity is the most expensive form of growth financing and dilute the shareholders return. External equity should only be used as a last resource to finance a company.

An Example of Sustainable Growth.

Various sustainable growth rate formulas exist. Some of them analyse much detail and take inflation, interest rates, external equity and various components of a business into account. 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 above formula takes the rate of return, financial leverage and dividend policy of a company into consideration. It is based on the following premises:

  • It is not practical (or possible) to issue more shares (dilute equity).
  • The company is effectively managed and the profit margin and asset turnover is at optimum levels.
  • The dividend payout is at the minimum level to keep the shareholders at ease.If we take a company with the following performance indicators:
  • The debt/equity level is at an optimum 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 tax) – $8 million
  • Equity – $20 million
  • Total assets – $50 million
  • Dividend Payout – 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 that it can grow it sales at a maximum of 24%. The company’s turnover can thus increase from $100 million to $124 million. If the company grow faster than 24% with its current parameters it is actually creating cash flow problems and this can finally lead to bankruptcy.

How can a company grow faster?

If a company wants to grow faster than what their sustainable growth rate indicates and they don’t want to dilute their equity they need to generate more finances through one or more of the following:

  • Higher profitability – this can be achieved by several factors such as higher gross margins and lower expenditures.
  • Better asset management – this can be achieved by creating more sales and profits in relation to assets and to decrease stock levels and debtor days.
  • A higher retention ratio – the majority of profits are ploughed back into the business.
  • A higher debt ratio – asset expansion is financed mostly by debt.

Summary

Growth is extremely important for any company to survive, gain market share, get a competitive edge and to position itself for harvesting. Uncontrollable growth is, however, just as damaging as very low growth and can put a serious strain on a company’s cash flow and can even lead to bankruptcy.

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

Sustainable growth should form an integral part of the strategy of any company and should be managed professionally.

Copyright© 2008 by Wim Venter. ALL RIGHTS RESERVED.

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