Cash Flow From Assets Vs Cash Flow To Stock Stockholders Business Growth – Grow Sustainably Or Go Bankrupt

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Business Growth – Grow Sustainably Or Go Bankrupt

A particular problem in financial planning is growth and growth management. Growth is not always a blessing. Many companies are in financial distress, have cash flow problems or even go bankrupt while they have full orders. There can be several reasons for this phenomenon. One of the major causes is the fact that companies are growing too fast to be supported by their strategic financial resources.

Higher turnover means higher assets in the form of inventories, 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 to which the company has access. The biggest constraint to sustainable growth is therefore the ability to generate sufficient capital to finance the increase in assets (increasing working capital needs). Non-financial resources that must also grow sustainably include company systems and the skills and experience of employees.

The importance of growth

Growth is necessary for a business to survive. Strategically, a company needs to grow to increase its market share and achieve a competitive advantage over its competitors. Other important advantages of growth are the company’s assets that can be used more optimally, the economies of scale that occur, and the profitability that can be increased. In the final analysis, growth is extremely important to optimally positioning a company for harvesting purposes.

Determinants of sustainable growth

Sustainable growth depends on the rate at which a company can generate assets and use those assets efficiently. The maximum rate at which a company can increase its sales without depleting its financial resources is called the sustainable growth rate. The main drivers of sustainable growth are rate of return, financial leverage, dividend policy and external equity capital.

  • Rate of Return – The rate of return that a business achieves is the basis of how fast the business can grow. A company’s profit margin (after taxes) multiplied by its asset turnover (sales divided by total assets) gives the company’s rate of return or return on assets (ROA).
  • Financial leverage – A company often uses debt to leverage its constant rate of return (ROA) to achieve a much higher return on equity (ROE).
  • Dividend Policy – A company’s dividend policy is a critical variable in manipulating the sustainable growth rate. A dividend payout of 50% allows a company to grow only half as fast as a similar company without a dividend payout.
  • External equity – External equity is the most expensive form of financing growth and reduces shareholder returns. External equity capital should only be used as a last resort to finance a business.

An example of sustainable growth.

There are different formulas for the rate of sustainable growth. Some of them analyze in great detail and take into account inflation, interest rates, external capital and various components of the company. A basic formula (designed 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 the rate of return, leverage and dividend policy of the company. It is based on the following premises:

  • It is not practical (or possible) to issue more shares (diluted equity).
  • The company is efficiently managed, and the profit margin and asset turnover are at an optimal level.
  • Dividend payout is at a minimum level to keep shareholders calm. If we take a company with the following performance indicators:
  • The level of debt/equity is at an optimal level according to 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 dollars
  • Capital – 20 million dollars
  • Total funds – 50 million dollars
  • Dividend payout – 0.4 (40%).

Therefore:

  • Net Profit Rate = 8/100 = 8%
  • Asset turnover = 100/50 = 2
  • Leverage = 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%. The turnover of the company can thus increase from 100 million dollars to 124 million dollars. If a company is growing faster than 24% at current parameters, it is actually creating cash flow problems and this can eventually lead to bankruptcy.

How can a business grow faster?

If a company wants to grow faster than its sustainable growth rate indicates and does not want to reduce its equity capital, it needs to generate more finance through one or more of the following:

  • Higher profitability – This can be achieved through several factors such as higher gross margins and lower expenses.
  • Better Asset Management – ​​This can be achieved by generating more sales and profits on assets and reducing inventory levels and debtor days.
  • Higher retention ratio – most of the profit goes back into the business.
  • Higher proportion of debt – the expansion of assets is financed mostly with debt.

Summary

Growth is extremely important to any company’s survival, market share gain, competitive advantage and harvest position. Uncontrolled growth is just as harmful as very low growth and can seriously strain a company’s cash flow and even lead to bankruptcy.

Using financial indicators and models, company management can scientifically analyze the company’s optimal sustainable growth rate. A company’s sustainable growth rate can be increased if its factors can be managed more effectively.

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

Copyright © 2008 Wim Venter. ALL RIGHTS RESERVED.

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