Business Growth – Grow sustainably or go bankrupt

Business Growth – Grow sustainably or go bankrupt

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

Higher turnover implies greater assets in the form of shares, debtors and fixed assets. In order to achieve a sustainable growth rate, these assets must be financed through financial resources that are generated by a company or that can be accessed by a company. Therefore, the biggest constraint to sustainable growth is the ability to generate enough capital to finance the increase in assets (working capital needs are increasing). Non-financial resources that must also grow sustainably include the company’s systems as well as the skills and experience of its employees.

Importance of growth

Growth is essential to a company’s survival. 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 company’s assets that can be used more optimally, the economies of scale that occur, and the profitability that can be increased. After all, growth is critical to optimally positioning a company for harvest purposes.

Determinants of sustainable growth

Sustainable growth depends on the speed at which a company can generate funds and use them effectively. The maximum rate at which a company can increase its sales without exhausting 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 capital.

  • Rate of return – The rate of return that a company achieves forms the basis of how fast the company can grow. A company’s profit margin (after taxes) multiplied by its asset turnover (sales divided by total assets) gives the company’s rate of return or return on assets (ROA).
  • Financial leverage – A company often uses debt to use 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 sustainable growth rate. A dividend payout of 50% allows a company to grow only half as fast as a similar company without paying dividends.
  • Foreign capital – External capital is the most expensive form of financing growth and reduces shareholder returns. External 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. Some of them analyze in great detail and take into account inflation, interest rates, external capital and various components of the 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 payout ratio)

ROE = net profit margin * asset turnover * equity multiplier

The above formula takes into account the 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 capital).
  • The company is managed efficiently and the profit margin and asset turnover are at optimal levels.
  • The dividend payout is at the minimum level to appease shareholders. If we take a company with the following performance indicators:
  • The debt/equity ratio is at an optimal level given the company’s risk profile.

If we take a company with the following performance indicators:

  • Turnover (sales) – 100 million dollars
  • Net profit (after taxes) – 8 million dollars
  • 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 factor = 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 its internal financial resources effectively, it can increase its sales by a maximum of 24%. In this way, the turnover of the company can increase from 100 million dollars to 124 million dollars. If the company is growing faster than 24% at its current parameters, it is actually creating cash flow problems and this could eventually lead to bankruptcy.

How can a company grow faster?

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

  • Higher profitability – this can be achieved through several factors such as higher gross profits and lower costs.
  • Better asset management – this can be achieved by creating more sales and profits in terms of assets and reducing inventory levels and days debtors.
  • Higher retention rate – most of the profits are invested back into the business.
  • Higher debt ratio – asset expansion is financed primarily by debt.

Summary

Growth is critical for any company to survive, gain market share, gain competitive advantage, and position itself for harvest. However, uncontrolled growth is just as harmful as very low growth and can put a serious strain on a company’s cash flow and even lead to bankruptcy.

However, a company’s management can scientifically analyze the company’s optimal sustainable growth rate using financial ratios and models. A company’s sustainable growth rate can be increased if its determinants can be managed more effectively.

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

Copyright © 2008 by Wim Venter. ALL RIGHTS RESERVED.

#Business #Growth #Grow #sustainably #bankrupt

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