Analyze The Cash Flow Problems A Business Might Experience Business Growth – Grow Sustainably Or Go Bankrupt

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Business Growth – Grow Sustainably Or Go Bankrupt

Growth and growth management pose special problems in financial planning. Growth is not always a boon. Many companies are in financial trouble, have cash flow problems or even go bankrupt when they have full order books. There can be many reasons for this phenomenon. However, a major reason is that companies grow too fast to support their strategic financial resources.

High turnover includes high assets in the form of stocks, debtors and fixed assets. In order to achieve a sustainable growth rate these assets must be financed by financial resources generated by the company or can be accessed by the company. Therefore, one of the biggest constraints to sustainable growth is the ability to generate enough capital to finance the growth in assets (increasing working-capital requirements). Non-financial resources that also need to grow sustainably include the company’s systems as well as the skills and experience of its employees.

The importance of growth

Growth is necessary for a company to survive. Strategically a company needs to grow to increase its market share and gain a competitive edge against its competitors. Other important benefits of growth are better utilization of company’s assets, economies of scale and increased profitability. In the final analysis growth is very important to put the company in good shape for harvesting purposes.

Determinants of sustainable growth

Sustainable growth depends on the rate at which a company can generate funds and utilize 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. Key determinants of sustainable growth are rate of return, financial leverage, dividend policy and external equity.

  • Rate of return – The rate of return earned by the company forms the basis of how fast the company can grow. Multiplying a company’s profit margin (after tax) by its asset turnover (sales divided by total assets) yields the company’s rate of return or return on assets (ROA).
  • Financial benefit – A company often uses debt to leverage its fixed return on equity (ROA) to achieve a higher return on equity (ROE).
  • Dividend Policy – A company’s dividend policy is an important variable in manipulating the sustainable growth rate. A 50% dividend payout allows a company to grow only half as fast as a similar company without a dividend.
  • External Equity – External equity is the most expensive form of growth financing and reduces shareholder returns. External equity should be used only as a source of last resort to finance the company.

An example of sustainable growth.

Various sustainable growth rate formulas exist. Some of them do a more detailed analysis and take into account inflation, interest rates, external equity and various business factors. A basic formula (created 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 rate of return, financial leverage and dividend policy of the company. It is based on the following premises:

  • It is not practical (or possible) to issue more shares (equity diluted).
  • The company is effectively managed and the profit margin and asset turnover are at optimal levels.
  • Dividend payout is at minimum level to keep shareholders comfortable. If we take a company with the following performance indicators:
  • The debt/equity level is at an optimal level considering the company’s risk profile.

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 benefit = 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 its internal financial resources effectively, it can increase its sales by a maximum of 24%. Thus the turnover of the company can increase from $100 million to $124 million. If the company grows faster than 24% with its current parameters, it is actually creating cash flow problems and this may eventually lead to bankruptcy.

How can a company grow faster?

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

  • High Profitability – This can be achieved through several factors such as high gross margins and low costs.
  • Better asset management – ​​This can be achieved by generating more sales and profits in relation to assets and reducing stock levels and debtor days.
  • High retention ratio – Most of the profits are returned to the business.
  • High Debt Ratio – Asset expansion is mainly financed through debt.

Summary

Growth is critical for any company to survive, gain market share, gain a competitive edge and position itself for harvest. However, uncontrolled growth is just as harmful as low growth and can put 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 increase if its determinants are managed more effectively.

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

Copyright © 2008 by Wim Venter. All rights reserved.

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