Sustainable Growth

For businesses, growth is seen as essential. The quicker a business can grow the better, right? Well, let us find out. First of all, if you feel pressure to grow because your product is demanded on the market, congratulations! That means you have solved the biggest headache of most entrepreneurs. Many businesses fail precisely because a fresh entrepreneur misjudged the demand.

A textbook definition of growth is improving the Income Statement’s top line — the Sales Revenue. It is logical that if expansion implies buying extra fixed assets (equipment, vehicles, machinery), it requires extra capital. But what we often forget is that growth would always imply investing more in Working Capital too.

What is working capital? Besides Fixed Assets, some of company’s money is always tied in operations. You can’t let your stock go down to zero, otherwise you will interrupt operations. Also, there are always some customers that buy on credit, there are always some suppliers that require prepayment, and so on. Roughly expressed, the funds constantly tied in your business cycle are called Working Capital (WC).

As opposed to a common belief, as long as your business operates at the same level, the WC stays tied — you can’t free it up, unless you wind down. It is a misconception to believe you will return the loan you borrowed for an increase of the working capital in a month after you sold the first batch. Whereas for a stagnating business the amount of capital tied in WC remains stable, expanding your operations will require an increase in WC.

In ISBI courses we teach entrepreneurs to manage their WC needs for both scenarios: stability and growth. What they learn is that growth above Sustainable Growth Rate (SGR) can easily drive the company into insolvency. Additional funding of WC required by extensive growth can deplete your resources quicker than you think. So, what is an SGR and how is it calculated?

Sustainable growth rate is the maximum growth rate which a firm can sustain without having to increase its financial leverage.

The capital structure of a business is the proportion of debt to equity, i.e. of borrowed vs. owner’s funds. If this proportion changes, for example, you take on more debt without injecting more equity or the other way around, we are talking about changing the capital structure. Banks carefully monitor clients’ leverage as one of the most important risks company is exposed to. If your leverage increases, bank can easily become reluctant to provide additional financing. On the other hand, all other things being equal, it is assumed that bank will willingly provide additional financing for growth under the condition that it will not increase your leverage over and above a level approved earlier.

In short, it comes to your profitability, precisely Net Profit compared to Equity = Return on Equity = ROE.

SGR = ROE

Therefore, if your Equity increases by 20% due to the Net Profit from last period, there are good chances that your bank will be ready to increase financing by the same percentage. For instance, if your company is financed as follows: 6M by the bank (Debt) and 10M by your money (Equity). Last year you made a profit of 2M (corresponding to ROE of 20%) and thereby the Equity is now 12M. The assumption is that your bank will be ready to provide you with additional financing of 1.2M, because it will be the same leverage as before (6 to 10 vs. 7.2 to 12).

But if you take a part of your profits out, i.e. pay yourself (and maybe other co-owners) dividends, then you have less resources to invest into expansion. The proper generic formula is:

SGR = ROE * (1 — dividend pay-out ratio)

Imagine, you spend 1.5M. out of your above mentioned 2M (pay-out ratio 75%); it will mean that your SGR is 0.05 or 0.20 * (1–0.75). This means that the company can safely grow at a rate of 5%. If the company wants to accelerate its growth past this threshold up to, say, 7%, it must seek extra funding.

How can you increase the SGR?

1. Logically, you can take less profit out of the company and plough everything back. Luxury lifestyle will have to wait.

2. You can slightly increase your prices. This will take away some market pressure, but raise your profit margin, what in turn increases your ROE and thereby SGR. Just be careful, you don’t want to scare away all your customers.

3. As an alternative to the above, you may optimise you cash conversion cycle by introducing more stringent policies with regards to receivables (i.e. reducing the crediting period to your clients). But you may also be able to increase your payables period by negotiating with your suppliers to increase the crediting period they grant to you.

4. You can look for ways to optimise your operations to squeeze every penny out of your capital already employed before you actually expand. This makes all the sense in the world. Why grow inefficiencies after all, better get rid of them first.

5. In addition, you can consider eliminating less productive business lines outside your core activity.

6. You can also free up some capital by outsourcing some fixed assets instead of buying them: lease or hire them. It may slightly reduce your Net Profit, but remember: your operations are more efficient if you achieve the same results with less assets employed.

7. Similarly, you may outsource some capital-intensive activities, like transport or import directly from oversees. Just ensure that you do not outsource anything that is your competitive advantage.

8. Finally, you can find investors ready to inject additional equity into your enterprise and finance growth with fresh equity. This will obviously lead to dilution of current ownership rights. But then sharing a bigger pie may still be better than having a small pie all for yourself.

It is essential to manage growth through proper financial planning. Growing too quickly may deplete your resources and result in insolvency and eventual bankruptcy. Growing at a rate lower than your SGR means that you are not using capital efficiently. Slow growth usually (if everything else goes well) results in cash surpluses. This, contrary to expectations, is not necessarily a good thing because it shows that there is a part of capital idling, and the company does not have profitable investment opportunities.

As the adage goes, failing to plan is planning to fail. Planning for your growth is key to ensure you don’t grow broke.