The economy that we have been experiencing in the last two years is difficult, but there are a few bright spots here and there. I have run into several small companies that have been doing quite well; so well that they are actually outgrowing their ability to sustain growth. In a previous Blog Posting, I discussed this (It’s Cash that Counts) and how to use a Capital Balance sheet to determine Working Capital. In addition, there is a formula that you can use to determine how much growth a company can sustain without external investment; here is how it works.
The formula for growth that can be sustained within the company has four elements:
Profitability: this is simply your net income divided by sales
Dividend Payout Ratio: a calculation of the percentage of net income that is paid out in dividends (or profit sharing or other use of net income that is not retained in the company). Net income paid out in dividends cannot be used as working capital. In many small companies, there are no dividends, so that this is not part of the equation.
Asset Utilization: How well your company uses your assets can be determined by dividing your company’s assets by your sales. Even if you are not studying your growth rate, this calculation is interesting because it tells you what sales you are generating for each $1 of assets that your company maintains.
Leverage: Your company’s assets divided by the portion of assets represented by equity (assets less debt).
Here is an example of an equation representing the sustainable growth rate of a company:
0.012 x 0.5 x 3.55 x 1.79 = 3.9%
In other words, the company represented by this equation can only grow at a rate of 3.9% a year without running out of cash. The formula can also give you some ideas on how to increase the sustainable growth rate.
- The company could increase profitability. If the company had 3% profitability, for example, its growth rate would be 9.6%.
- Increase retained earnings: keeping more of the cash can help the company in the long term. Given the low profitability rate (and consequently the low sustainable growth rate), cutting dividends in half would increase the growth rate to 5.7%.
- Increase asset utilization. This could be difficult based on the industry. All the same an increase in asset utilization rate to 5 would increase the growth rate to 5.4%
- Increase Leverage (debt). When times are good, this can an effective strategy to increase growth rate. Leverage is a double edged sword (as we have seen over the last two years), and when business goes down hill, leverage can magnify a negative in the same way it does a positive.
If you are not able to change one of these internal measures to increase the sustainable growth rate, then other alternatives must be considered, such as increasing outside investment. Barring that, a company must be careful not to exceed their sustainable growth rate, else a cash crunch will follow.