Grow! Grow! Grow!

It comes as quite a surprise to many managers when they learn that growth is not always a blessing. Rapid growth can put considerable strain on a company’s resources, and unless management is aware of this effect and takes active steps to control it, rapid growth can lead to bankruptcy. Many companies that grew too fast met the market test by providing a product people wanted and failed only because they lacked financial acumen to manage their growth properly. Companies growing too slowly have a different but no less pressing set of financial concerns. As will become apparent, if these companies fail to appreciate the financial implications of slow growth, they will come under increasing pressure from restive shareholders, irate board members, and potential raiders.

The sustainable growth rate (SGR) is the maximum rate at which a company’s sales can increase without depleting financial resources. An important conclusion is that growth is not necessarily something to be maximised.

Successful companies pass through a predictable life cycle.  Firstly, the start-up phase in which the company loses money whilst developing products and establishing a foothold in the market. This is followed by a growth phase in which the company is profitable but growing so rapidly that it needs regular infusions of outside financing. The third phase is maturity, characterised by a decline in growth and a switch from absorbing external financing to generating more cash than the firm can profitably reinvest. The last phase is decline, during which the company is perhaps marginally profitable, generates more cash than it can reinvest and suffers declining sales.

It is during the initial phase that financing needs are most pressing. Increasing sales require more assets of all types, which much be paid for. Retained profits and the accompanying new borrowing generate some cash, but only limited amounts. Unless the company is prepared to sell common stock or borrow excessive amounts, this limit puts a ceiling on the growth it can achieve without straining resources. This is the firm’s SGR.

The sustainable growth equation assumes:

  1. The company has a target capital structure and a target dividend policy it wishes to maintain
  2. Management is unable or unwilling to sell new equity

If the company wants to increase sales during the coming year it must also increase assets such as inventory, account receivable, and productive capacity. Because the company will not be selling equity by assumption, the cash required to pay for this increase in assets must come from retained profits. When a company experiences unbalanced growth of either the surplus or the deficit variety, it can move towards balance in any of three ways; It can change its growth rate, alter its return on assets or modify its financial policies

Calculating the Sustainable Growth Rate

where SE_{bop} is the value of shareholders equity at the beginning of the period in question (typically the start of the year)

SGR = \frac{Net Income}{Sales} * \left ( 1-\frac{Div}{Net Income} \right )*\frac{Sales}{Assets}*\frac{Assets}{SE_{bop}}

What to do when Actual Growth Exceeds the SGR?

The first step is to determine how long the situation will continue for. If the company’s growth is likely to decline in the near future as the firm reaches maturity, the problem is only a transitory one that can probably be solved by borrowing. For longer-term problems, some combination of the following strategies is required.

  1. Sell new Equity
  2. Increase financial leverage
  3. Reduced the dividend pay-out
  4. Prune away marginal activities
  5. Outsource some or all of production
  6. Increase prices
  7. Merge with a “cash cow”

Sell New Equity

The increased equity becomes a source of cash in which to finance further growth. The problem with this strategy is that it is unavailable to many companies and unattractive to others. Selling equity is a difficult undertaking because without active stock market trading of the new shares, new investors will be minority owners of illiquid securities. Consequently, those investors interested in buying the new shares will be largely limited to family and friends of existing owners.

Even in countries with active stock markets many companies find it very difficult to raise new equity. This is particularly true of smaller companies that, without a glamorous product, find it difficult to attract the services of an investment banker.

Finally, even many companies who could raise equity choose not to do so.

Increase Leverage

If selling equity is not possible, two other financial remedies are possible. One is to cut the dividend payout ration and the other is to increase financial leverage. A cut in the payout ratio raises the SGR by increasing the proportion of earnings retained in the business, while increasing the leverage ration raises the amount of debt the company can add for each dollar of retained profits. Leverage is the default option of many firms. However, there is an upper limit of the company’s use of debt financing.

Reduce the Pay-out Ratio

Just as there is an upper limit to leverage, there is a lower limit of zero to a company’s dividend payments, and most companies are already at this limit. Fully 60% of the 7,000 public companies, as measured by Standards & Poor’s paid no dividend at all. If owners believe that retained profits can be put to productive use earning attractive rates of return, they will happily forego current dividends in favour of higher future ones. On the other hand, if company investment opportunities do not promise attractive returns, a dividend cut will anger shareholders, prompting a decline in the share price.

Profit Pruning

Beyond modifications in financial policy, a company can make several operating adjustments to manage rapid growth. One is called “profit pruning”. During the 1960’s and early 1970’s some financial experts emphasised the merits of product diversification. The thought was that, as long as income streams were not affected in exactly the same why by economic events, the variability inherent in each stream would “average out”. Whilst this might appeal to managers it does nothing for shareholders; if they wanted diversification they could simply purchase shares in the different companies. Secondly, because companies have limited resources, they cannot be important players in a large number of products at the same time.

Profit pruning recognises that when a company spreads its resources across too many products, it maybe unable to compete effectively in any. Better to sell off marginal operations and plough money back into the remaining businesses. It reduces the sustainable growth rate in two ways; it generates cash directly and it reduces actual sales growth be eliminating some of the sources of growth. Profit pruning can also work for a single-product company. Here the idea is to prune out slow paying customers or slow turning inventory; this frees up cash, reduces sales and increases asset turn over.

Outsourcing

A company can increase its sustainable growth rate by outsourcing more and doing less in-house. When company outsources, it releases assets that would other wise be tied up performing the activity and it increases asset turnover.

Pricing

When sales growth is too high relative to the company’s financing capabilities, it may be necessary to raise prices to reduce growth

What to do when sustainable exceeds actual?

The first step in addressing problems of inadequate growth is to decide whether the situation is temporary or longer term. If temporary, management can simply continue accumulating resources in anticipation of future growth. When the difficulty is longer term, the issue becomes whether the lack of growth is industry wide or firm specific. If the latter, the reasons for inadequate growth and possible sources of new growth are to be found within the firm. In this event, management must look carefully at its own performance to identify and remove internal constraints. When a company is unable to generate sufficient growth from within, it has three options:

  1. Ignore the problem by internally investing the money
  2. Return the money to shareholders
  3. Buy growth

Ignore the problem by internally investing the money

Management can continue to invest in its core business despite the lack of attractive returns, or it can simply sit on a pile of idle resources. Poorly utilised resources depress a company’s stock price and make a firm a feasible and attractive target for a raider. If a raider has done their sums correctly, they can redeploy the targets firm’s resources more productively and earn a substantial profit. Even if a hostile takeover does not occur, boards of directors and institutional shareholders are increasingly likely to give the boot to under-performing managers. Beneficial SGR’s occurs when the company invests in activities offering returns in excess of cost, including the cost of capital employed. Bad growth involves investing in activities with returns at or below cost. Furthermore, they waste valuable resources – and stock markets are increasingly adept at distinguishing between good and bad growth, and punishing the latter.

Return the money to shareholders

The most direct solution to  the problem of idle resources is to simply return the money to the shareholders but increasing the dividends or repurchasing the shares. However, while this solution is becoming more common, it is still not the strategy of choice amongst many executives. The chief reason is that many executives appear to have a bias is favour of growth, even when this growth creates little or no value for shareholders. At the personal level, many managers resist paying large dividends because the policy hints at an inability to perform a basic managerial function.

Buy Growth

The third way to eliminate SGR problems is to buy growth. Motivated by pride in their abilities as managers, concern for retaining key staff, and fear of raiders, managers often respond to excess cash flow by attempting to diversify into other businesses. Because time is a factor, this usually involves acquiring business rather than starting new ones from scratch. The growth problems of mature or declining company’s is usually the mirror of start-ups. Therefore, high and low growth firms frequently solve their respective growth management problems by merging so that the excess cash generated by one organisation can finance the rapid growth of the other.

Buying growth is distinctly inferior or returning money to owners. More often than not, the superior growth of the potential acquisition is already priced into their stock price, so that, the buyer ends up paying a substantial premium. The buyer is often left with a mediocre investment or worse.

Links
  1. http://en.wikipedia.org/wiki/Sustainable_growth_rate
  2. http://www.amazon.com/Analysis-Financial-Management-subscription-card/dp/007325858X
  3. http://news.morningstar.com/classroom2/course.asp?docId=3071&page=2&CN=COM

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