Grow for broke - avoiding the trap of growing too fast
Here's a cautionary tale of a business that was going well. It traded out of a single, profitable retail store. "But if we're making this much money with one shop," the directors thought, "we'd do even better with more shops." So they expanded, quickly opening four new shops around the country. The business couldn't handle this level of growth and was put into receivership. In this case, there was a moderately happy ending and a kinder fate than that of many who have fallen into this trap; the receiver closed the four new, unprofitable shops but was able to continue trading the profitable one. It is expected that it will trade out of receivership and be returned to its shareholders later this year.
"Even good businesses run into trouble through growing too fast," says David Crichton of Crichton Horne, the insolvency practitioners involved in this receivership. "Overstep or strike an unforeseen problem and you can lose the lot. Of course, these things can be solved if they're caught in time."
We sometimes see this type of growth problem as primarily an issue for brash new businesses. Not so. "It's not just new companies who grow too fast," says David Crichton. "It's any business in any industry which sees an opportunity without considering the extra capital, plant, and so on, that it will need."
In cases such as this it's easy to say in hindsight that the business would not be able to grow that fast. What I want to discuss in this article is how to identify the fact that intended growth will cause problems by using the tools of sustainable growth analysis, in particular the Du Pont model.
Sometimes in the rush for the latest and greatest management tool, valuable basic tools, developed long ago, are overlooked. Sustainable growth analysis is based on the reasonably obvious proposition that if the business is funding its growth out of profits, it can only grow as fast as those profits allow. As a presenter of accounting seminars for non-accountants I can assure you that this is not obvious to many managers, let alone to rose-tinted spectacle-wearing entrepreneurs.
A basic illustration to estimate sustainable growth is a bank deposit of $100,000 earning 5% per annum. The annual profitability of the investment is $5,000. If the investor reinvests 100% of the profits the sustainable growth is 5% i.e $100,000 + (0.05 x $100,000). However, if the investor withdraws 70% of the profits (or $3,500) the sustainable growth in the investment is only 1.5% i.e. $100,000 + ($100,000 x 0.05 x 0.3) (or $1,500). Intuitively the bank deposit cannot grow at more than 1.5% (the sustainable rate) if the investor continues to be paid out 70% of the profits.
If you can measure the sustainable growth of an organisation you can make an informed decision about what its capital requirements are and whether it is likely to meet its financial objectives.
To estimate a company's sustainable growth rate we can apply the following formula:
G = ROE x (1 – Payout Ratio)
| Where: | G = sustainable growth |
| ROE (Return on Equity) = Net income for the period / Owners equity atthe beginning of the period | |
| Payout Ratio = Dividends for the period/ Net income for the period |
Below are the abbreviated financial statements of Go-For-Broke Ltd:
| 2000 | 1999 | |
| Sales | 100,000 | 90,269 |
| Net Operating Profit After Tax (NOPAT) | 7,000 | 6,319 |
| Dividends | 3,150 | 2,844 |
| Total Assets | $ 56,418 | $ 62,500 |
| Debt | 20,704 | 22,936 |
| Owners' Equity | 35,714 | 39,564 |
| $ 56,418 | $ 62,500 |
Professor Gary Emery from the University of Oklahoma provides a good summary of the process an accountant (or a supplier's credit manager) might follow in assessing the viability of the growth plans (Business Credit, February 2000). He recommends the following steps to anticipate a company's future financial condition:
- Calculate sustainable growth rates for a period and compare them to actual growth rates. Examine periods of excess growth closely to determine how the growth occurred.
- Determine what the company's target growth rate is. Any rate that is within the sustainable growth limit will be acceptable. However, if it is greater than the rate calculated it will require a change in the operating or financial policies.
- Find out what provisions have been made for accomplishing growth objectives i.e. what changes are to be made to current financial and operating policies.
Based on Go-For-Broke's figures, for 2000, the relevant ratios are:
| ROE | 19.6% | (7,000/35,714) |
| Payout ratio | 45% | (3,150/7000) |
| Sustainable growth rate | 10.78% | (19.6% x 55%) |
Go-For-Broke cannot grow faster than 10.78% annually unless it changes its operating or financial policies e.g. decreases the payout ratio.
Analysis of the components of the ROE ratio tells a lot about the growth potential of an organisation. Many readers will no doubt know of Du Pont analysis, but do you actually use it?
Du Pont, the giant chemical company, attributed its huge growth to monitoring these key factors:
| ROE = | Total Assets(1999) Owners Equity (1999) |
x | Sales (2000) Total Assets (1999) |
x | Net Income (2000) Sales (2000) |
These 3 ratios are known respectively as:
| Gearing Ratio | 1.58 times |
| Total Asset Turnover Ratio | 1.77 times |
| Profitability Ratio | 7% |
Multiplying these ratios together will equal the ROE calculated above of 19.6%.
In Go-For-Broke's case the ratios tell you that:
- For each dollar invested by the shareholders $1.58 has been invested in assets
- For each dollar invested in assets sales of $1.77 have been generated
- For each dollar of sales 7 cents profit is earned
If Go-For-Broke wants to grow faster than 10.78% it must change one or more of these three ratios. This analysis highlights the only options for growth available to the company:
- Shareholders can inject more capital (gearing ratio). The shareholders are the lenders of last resort so this is an assurance to creditors.
- The dividend payout ratio could decrease (gearing ratio). More of the profits earned would be retained in the organisation rather than distributed to the shareholders.
- The company can increase its debt (gearing ratio). Obviously this increases financial risk.
- Assets can be employed more efficiently to generate more sales (asset turnover ratio). This could mean more efficient use of fixed assets and /or working capital. Fixed assets need to be examined to assess the current capacity utilisation to see if there is any slack, or unused capacity. Working capital efficiency is measured by average stock turnover, average debtors collection period and creditors settlement period. The idea is to manage working capital as tightly as possible so at any point in time the minimum amount of capital is invested. This is more difficult than it may at first appear because there is always the trade-off between low inventory levels and not being able to meet customers' demands.
- The profit margin could increase by reducing costs (profitability ratio).
Of course, assessing the credibility of growth expectations is another issue altogether. My point is that this clearly illustrates that companies must change their operating or financing policies to achieve a growth rate greater than their sustainable growth rate. A lot of pain can be avoided by sorting this out at the start, rather than relying on an insolvency practitioner to solve the problems at the end.
Susan Hansen is an accountant and management consultant.