How To Tell If Ready To Feed Formula Is Spoiled Business Growth – A Case Study on Good Vs Bad Growth

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Business Growth – A Case Study on Good Vs Bad Growth

Growth is central to human nature. The same principle applies in business. Decline in growth often signals problems in the business and if not reversible, it can mean the demise of the business. Entrepreneurs are largely measured by growth and typically actively seek to maximize growth and gain as much market share as possible. If this growth is not properly managed, it can be detrimental and damage or even destroy the company financially.

For more than ten years, Ventex Corporation has tracked and advised the growth patterns of several companies. This case study focuses on two manufacturing companies in the same industry. Details are changed for confidentiality purposes – however, all details simulate real-life scenarios closely enough to demonstrate actual learning. The following points highlight the key figures for the two companies over five years:

  1. Company A’s turnover increased from $78.9 million to $348.7 million. Company B’s turnover was more under control, increasing from $77.5 million to $178.9 million.
  2. Company A’s profit margins (net profit divided by turnover) fell from a low of 2.5% to 1.2%. Company B’s profit margin increased from 4.1% to 16.8% in the same period.
  3. Asset turnover (turnover divided by total assets) of both companies was relatively stable over time. Company A’s average was 2.3 and Company B’s average was 1.9.
  4. Leverage (debt plus equity divided by equity) was 19.1 in Company A’s first year and fell to 12.3 by year five. In comparison, Company B’s leverage was 3.0 in the first year and fell to 1.6 by the fifth year.
  5. Company A put all profits back into the business, except in the third year when the retention rate was 74%. Company B’s retention ratio was 100% throughout the period.
  6. Sustainable growth metrics showed that Company A could grow to a maximum of $301.7 million by year five (they grew to $348.7 million) and Company B to $184.3 million (they grew to $178.9 million).

Both companies were analyzed in detail. One of the most important insights came from using the basic sustainable growth rate (SGR) formula developed by Hewlett-Packard:

SGR = ROE*r where:

SGR = sustainable growth rate

r = retention rate (1 – dividend payout ratio)

ROE = net profit margin * asset turnover * equity multiplier (financial leverage)

The sustainable growth rate is based on last year’s indicators. If a deficit occurs over a long period of time (the actual turnover is greater than the turnover planned according to the sustainable growth formula), there is a high probability that the company will get into financial difficulties and even bankruptcy. This is exactly what happens with Company A. In contrast, Company B grew below their sustainable growth rate and they kept their financial health intact and became a very strong player in their industry.

What were the differences between these companies? Both companies started with similar revenue ($78.8 million vs. $77.5 million). Analyzing companies reveals four important differences:

  1. Company A has a much lower profit margin than Company B (an average of 1.4% per year compared to 10.4%). Company B’s profitability actually increased over time. Further analysis revealed that Company A cut prices and often engaged in unprofitable business to gain market share. Their gross profit margins averaged less than 20%, compared to Company B’s more than 30%. Company B often abandoned bad business and focused on selling its products on the basis of value-added services.
  2. Company A financed its growth with extremely high debt compared to Company B (an average annual leverage of 11.3x compared to 2.2x). A deeper analysis of Company A showed that the initial leverage of 19.1x was unsustainable, and the company subsequently sold equity to finance growth and lower its debt ratio. This is not enough and eventually the high level of debt came to haunt them. In contrast, Company B used less debt and they nearly halved their leverage over the period. They are extremely liquid and soluble these days.
  3. Company A paid a 26% dividend in the third year. This provided critical importance at this stage. Further analysis showed that they may actually have had a surplus (actual sales minus target sales based on sustainable growth rate) of $3.3 million in the fourth year instead of a deficit of $7.8 million. Company B invested all their profits back into the company and they reaped the profits later. Further analysis actually showed that their expenses (including director/shareholder salaries) were much lower than Company A’s.
  4. Ultimately, Company A was consistently growing faster than they could afford. By the fifth year, they had sales of $348.7 million – leaving a $47 million deficit. They were unable to finance this additional deficit and this led to their eventual demise. In comparison, Company B grew to $178.9 million by year five – $5.4 million less than their target revenue based on their sustainable growth rate. The company could easily afford this growth.

A detailed analysis revealed many other differences between the two companies. Company A’s strategy turned out to be unbridled growth, lack of financial discipline, unnecessary risks, early profit taking and lack of focus. The company was eventually liquidated.

On the other hand, company B chose a strategy of controlled and sustainable growth, strict financial discipline, limited risk and focus on profitable business. Today, the company is recognized as a market leader in its field and their harvesting potential is great with many international players already showing great interest in acquiring the company.

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