Every business owner wants to be successful; or at least all of the business owners I know do. However, there are a significant number of businesses that do not succeed in the long term because of how well they succeed in the short run. Most often, this is because the business grows more quickly than their cash flow allows (see Its Cash That Counts and A Simple Tool to Calculate and Track Cash Flow). Adequate cash flow is vital to the success of any business, and it is possible to analyze your company’s financials in order to predict the rate of growth that your cash flow allows.
Allowable Growth Rate will tell you how fast your company may grow without changing any external financial inputs, such as increasing equity financing or loans. The lesson here is to know what your company’s allowable growth rate is without such financial adjustments and then be ready to apply the adjustments when needed. Negotiate the additional equity or loan before you need it!
This posting will look at the Allowable Growth Rate Formula, and next week will follow with a practical example. Here is the formula for Allowable Growth Rate:
AGR = Net Profit Margin X Rate of Retention X Asset Turnover X Leverage
Net Profit Margin: The first term of the formula is simply the percentage of your net profit, which is Net Income divided by Revenues. The formula presumes that the first source of operating cash is your company’s profits. Recall that I mentioned above that this formula addresses the allowable growth rate without external financial inputs. If your company does not yet have net profit, you will automatically need external financial inputs in order to operate at all, let alone grow.
Retention Rate: Retention rate refers to the amount of Net Profit that is retained within the company. For example, the company may be obligated to pay a dividend out of profits, or as the owner, you do not take any personal salary until after all other expenses are met. The retention rate is calculated by dividing the amount of profit retained in the company by the total of net profit.
Asset Turnover: Asset turnover refers to the number of times in a year that your company uses a dollar to move its operations forward. It is calculated by dividing the company’s Total Assets from the Balance Sheet by Revenues. Asset Turnover is a way of looking at how efficient your company is with its resources. This is important for determining your company’s growth rate: the more efficient that your company uses its resources, the greater the allowable growth rate.
Leverage: Although not everyone agrees with me when I state it like this, but Leverage basically tells us who owns what in a company (see DuPont Analysis: Capital, Debt and Equity). If the total capital in a company is $150,000, and the owner’s equity is $100,000, then that means that there is also $50,000 in debt (belonging to the bank or other individual or entity). In this case, capital divided by equity equals 1.5. Debt is used as a lever to increase the amount of capital available to operate the company. In many small companies, there is no leverage because the company has not taken on debt.
Next week, a practical application of the formula.