The Formula For Equity In A Combined Margin Account Is: Business Growth – Grow Sustainably Or Go Bankrupt

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Business Growth – Grow Sustainably Or Go Bankrupt

Economic growth and its management create special problems for financial planning. Growth is not always a blessing. Many companies struggle financially, have cash flow problems or even go bankrupt when they have full order books. There may be several reasons for this phenomenon. However, one of the main reasons is the fact that companies are growing too fast for their strategic financial resources to support them.

Higher turnover means higher assets in the form of inventory, debtors and fixed assets. In order to achieve a sustainable rate of growth, these assets must be financed with financial resources that the company has generated or has access to. Thus, the biggest constraint to sustainable growth is the ability to generate enough capital to finance asset growth (the need for working capital increases). Non-monetary resources, which must also grow sustainably, include company systems as well as the skills and experience of employees.

The importance of growth

Growth is essential for business survival. A company needs to grow strategically to increase its market share and gain a competitive advantage over its competitors. Other important benefits of growth are the company’s assets that can be used more optimally, economies of scale that arise, and profitability that can increase. Ultimately, growth is critical to optimally positioning a business for growth.

Determinants of sustainable growth

Sustainable growth depends on how much money a company can generate and use those funds effectively. The maximum rate at which a company can increase its sales without exhausting its financial resources is called the sustainable growth rate. The main drivers of sustainable growth are yield, financial leverage, dividend policy and foreign capital.

  • Rate of return – The rate of return a company can achieve is the basis for how fast the company can grow. A company’s profit margin (after taxes) multiplied by asset turnover (turnover divided by total assets) gives the company’s profitability, or return on assets (ROA).
  • Financial leverage – A company often uses debt to leverage a 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 50% dividend payout allows a company to grow half as fast as a similar company without paying out dividends.
  • Foreign capital – External capital is the most expensive form of financing growth and dilutes shareholder returns. External capital should only be used as a last resort to finance a business.

An example of sustainable growth.

There are various formulas for the sustainable growth rate. Some of them analyze a lot of details and take into account inflation, interest rates, foreign capital and different components of the company. A basic formula (created by Hewlett-Packard) that is very useful is:

SGR = ROE*r

where:

SGR = sustainable growth rate

r = retention rate (1 – dividend payout ratio)

ROE = net profit margin * asset turnover * equity multiplier

The above formula takes into account the company’s rate of return, leverage and dividend policy. It is based on the following foundations:

  • It is not practical (or possible) to issue more shares (dilute equity).
  • The company is managed efficiently and the profit margin and asset turnover are at optimal levels.
  • Dividends are paid at a minimum level so that shareholders can have peace of mind. If we take a company with the following performance indicators:
  • The debt/equity level is at an optimal level considering the company’s risk profile.

If we take a company with the following performance indicators:

  • Turnover (sales) – 100 million dollars
  • Net profit (after tax) – 8 million dollars
  • Equity – 20 million dollars
  • Total assets – 50 million dollars
  • Dividend payout – 0.4 (40%).

Therefore:

  • Net Profit Margin = 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 the company uses all its internal financial resources effectively, it can increase its sales by a maximum of 24%. The company’s turnover can thus increase from 100 million dollars to 124 million dollars. If a company grows faster than 24% under the current parameters, it will actually create cash flow problems and may eventually lead to bankruptcy.

How can a company grow faster?

If a company wants to grow faster than their sustainable growth rate indicates, and they don’t want to dilute their equity, they need to generate more cash through one or more of the following methods:

  • Higher profitability – This can be achieved through several factors such as higher gross margin and lower expenses.
  • Better Asset Management – ​​This can be achieved by generating more sales and profits on assets and reducing inventory and debtor days.
  • Higher retention rate – more of the profits are plowed back into the business.
  • Higher debt ratio – asset expansion is predominantly financed by debt.

Summary

Growth is critical for any business to survive, gain market share, gain competitive advantage, and position itself for harvest. However, uncontrolled growth is just as harmful as very low growth and can seriously strain a company’s cash flow and even lead to bankruptcy.

However, the management of the company can scientifically analyze the optimal sustainable growth of the company with the help of financial ratios and models. The sustainable growth of a company can be increased if its determinants can be managed more effectively.

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

Copyright © 2008 by Wim Venter. ALL RIGHTS RESERVED.

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