In last week‘s posting (Sustaining Growth), I introduced a model that would allow a small business owner to understand how fast their company may grow without external financial inputs. In other words, how quickly can your business grow without running out of cash and without infusing new cash from equity or loans. In addition, the model also allows a small business owner to see how other changes and improvements might
The Allowable Growth Rate model that I introduced last week is:
AGR = Net Profit Margin x Rate of Retention x Asset Turnover x Leverage
Let’s take a look at an example: a small business has sales of $900,000, with Cost of Goods Sold (COGS) of $350,000, Sales and General Administration (SG&A) costs of $400,000 for a Net Profit of $150,000. In addition, the company’ owner pays a dividends $100,000 to investors. The business has Capital of $450,000, of which $300,000 is debt and the rest equity.
AGR = 16.7% x 33.3% x 2 x 2 = 22.2%
AGR = $900,000 x 22.2% = $200,000
Simply put, with retained earnings of $50,000 (after dividends), the company turns assets over 2 times a year, and has leverage of 2, meaning that internal operations will allow the company to turn the $50,000 of retained earnings into $200,000 of new sales without external funds.
Supposing, however, that the product or service that the company sells has made a hit in the marketplace, and sales could grow much more quickly than that. If the company expands more rapidly, they will be pinched by a lack of capital to sustain the growth.
If it is possible to make improvements internally, you should try. For example, if the company can decrease Cost of Goods Sold, Sales or General Administration Expenses, each dollar saved would be another dollar to be reinvested into the business, all things being equal. For example, a decrease in COGS and SG&A of just 5% would increase Net Profit and AGR as follows
AGR = 20.8% x 46.7% x 2 x 2 = 38.9%
AGR = $900,000 x 38.9% = $350,000
You could also analyze other operations. What if the company could use its assets more efficiently, thus increasing capital turnover? This would allow them to create more sales with the same assets, thus increasing AGR, again without external financial inputs. The following example assumes that the company is able to increase asset turnover from 2 to 3, increasing revenue to $1,350,000. We also assume that COGS and SG&A will increase by roughly 1/3, as would dividends. The resulting equation for AGR is
AGR = 27.8% x 65.3% x 3 x 2 = 108.9%
AGR = $900,000 x 108.9% = $1,470,000
Of course, not every company is simply going to increase asset turnover by 50%, but this illustrates how internal change can have a significant effect on financial performance. In reality, you would always want to look at improvement in internal operations as a way to increase AGR, before looking at external financial inputs, such as debt or equity. If you were to seek external financing, a good investor or bank partner is going to want to look at improvements anyway.
Next week, we will have another practical example looking at how increasing debt or equity financing could affect Allowable Growth Rate.