How much growth can your business sustain? __________________ By Jose T. Valencia
How much growth can your company or a business sustain without borrowing more money and why is this information important in managing your business? One of the important goals of every business owner or chief executive is to maximize shareholder value, and one of the key drivers to maximizing shareholder value is growing the company’s top line — revenues. Generally, the faster the growth in revenues, the higher the shareholder value. However, unrestrained or unmanaged growth may lead to below par performance or a liquidity crisis. The measure of how much a firm can grow without borrowing more money is known as the “sustainable growth rate (SGR).” At this growth rate, the internally generated cash flow of your company is sufficient to finance the increase in funding requirements as a result of the growth. Growing beyond this rate will require your company to borrow more money, which will in turn affect its gearing ratio and ultimately its cost of capital. Other factors remaining constant, a high cost of capital translates to lower shareholder value. The measure of sustainable growth (that I learned from school) is Return on Equity multiplied by Retention Ratio. Return on Equity on the other hand is defined as Return on Net Assets multiplied by Leverage. Understanding each of the variables of the SGR measure provides information that will be very useful in managing your business and in formulating short-and long-term strategies to grow your company’s shareholder value. For example, return on net assets can be broken up into two ratios: the profitability ratio and the turnover ratio. Profitability is the ratio of net profit to sales while turnover is the ratio of sales to net assets (net assets typically consist of working capital and fixed capital). So, in a highly competitive industry where margins are not easily increased, you may re-focus efforts at increasing the turnover ratio in order to achieve an improvement in return on net assets. Every business requires investments in both working capital and fixed capital. As your business grows, so will the investment in working capital and fixed capital. Working capital generally refers to trade receivables and inventories less supplier credits. Fixed capital, on the other hand, refers to the machinery and equipment, land or building and other property and equipment used in the business. If the growth in revenues is within the SGR and the profit margin is the same, generally, the internally generated cash will be sufficient to fund the additional investments in working capital and fixed capital. Increasing profit margin is not the only way to increase return on net assets and consequently, SGR. Your company can improve its return on net assets by increasing turnover, meaning increasing sales while keeping working capital and fixed capital constant or reducing net assets while keeping sales the same. Examples of working capital reduction strategies include shorter collection period, lower inventories and longer supplier credits. Lower inventories may be achieved by improvements in the supply chain, shorter lead time, adopting better warehousing techniques, enhancing production efficiencies, etc. Another way to increase your company’s SGR is to work on its leverage or gearing ratio. Gearing ratio is arrived at by dividing net assets over equity. So, a gearing ratio of one means that all of the company’s net assets are financed using equity. As you will note from the SGR formula, the higher the gearing ratio, the higher the SGR, all others being equal. This suggests that putting debt in your balance sheet or financing growth through debt can be a good thing for a company. A word of caution though – this will only work if your company’s return on net assets is higher than the interest rate. Also, too much debt can be harmful. Finding the right mix of debt and equity, otherwise known as the optimal capital structure, is one of the many challenges facing the leadership of any business. Retention ratio, as the name suggests, is the amount of profit that is not declared as dividends to the company’s owners. The formula for the retention ratio is one minus the dividend payout ratio. The more profits that are regularly distributed to the owners, the lower the SGR. The analysis model can be applied at the company level and at a division or product level. In other words, your company’s SGR can be disaggregated into its various divisions or product lines. And the strategies for one product line may be different from other products, depending on the stage of a product in its life cycle. Strategies for enhancing returns on net assets for products at maturity stage will be quite different from products in the introduction or growth stage. In applying the model to your business, care should be taken in determining the values of the different variables. For example, net assets should only include those assets that are used in the business. Non-operating assets or assets that are held for speculative reasons like real estate properties not used in the business should not be included in the net asset value. The SGR formula looks simple but it can be a powerful tool in understanding the business and in developing strategies to create more value for your company’s shareholders. |