Matching Growth, Financial Resources is a Balancing Act

By NH SBDC Staff

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Times are good.  Business is up.  Owners and managers can relax a bit – loosen their grip on costs and turn their attention to boosting sales and growing the company; making hay while the sun shines.  After all, aggressive growth can contribute significantly to the bottom line and strengthen the company’s market position.  It can also result in bankruptcy.

It takes money to grow.  As sales increase, so does the need for additional assets to support the new sales levels – more inventory, higher accounts receivable for example.  If sales growth exceeds the financial resources necessary to fund an increase in assets, cash flow begins to dry up and the boundless growth opportunity turns out to be, at best, unsustainable and, at worst, lethal.

Assets must be financed with profits, new debt or additional equity.  Before considering taking out new debt or looking for investors, it might be useful to determine just how much growth the company can sustain given its current resource base.  Here’s a “quick and dirty” way to determine a sustainable growth rate using profitability and something we’ll call variable assets and variable liabilities.

First determine the company’s net profit after taxes as a percent of sales.  For example, if sales are $100,000 for a given period and profits $2,000, the number would be .02.  This assumes all profits are retained in the business and not distributed as dividends, bonuses, etc.

Then add up all assets that tend to vary with sales levels.  They might include cash, accounts receivable, inventory and prepaid expenses; they could also include equipment.  If you are unsure of whether an asset varies with sales, include it.  The effect will simply be to make your growth target more conservative.  Express this number as a percent of sales, for example, if variable assets add up to $45,000 on sales of $100,000 the number is .45.

Now sum up variable liabilities such as accounts payable and any expenses accrued but not yet paid.  Include only those liabilities which vary as sales vary, for example, don’t add in any notes payable to the bank.  If liabilities are $20,000 on sales of $100,000 they would be expressed at 20.

Using the formula below, determine the company’s maximum sustainable growth rate without incurring new debt or taking on outside investment.
In this scenario, the company’s growth is limited to 8.7 percent based on the relationship between the level of assets required to support those sales and the cash it is able to generate internally, i.e. from operations.  Needless to say, a certain amount of frustration will set in if the market suggests sales could grow are, say, 35 percent and the company is limited by financial constraints to 8.7 percent.  With this wide a gap it is probably safe to say that, even after internal operations are tuned to free up the most cash possible, some amount of new debt and/or equity will be needed of the company is to expand.

The thought process we’ve just gone through is somewhat different from that of many entrepreneurs faced with market opportunities and a chance to grow the business.  Rather than simply “go for it,” it suggests the need for a financial strategy to manage growth.  This begins with an understanding of the interrelationships between growth, the assets needed to support it and the liabilities necessary to fund them.  It means knowing that there are appropriate levels of debt in relation to a company’s equity, industry norms and the cost of borrowing; that there are optimum debts to equity ratios (leverage) which will yield maximum sustainable growth; that there are optimum growth rates to target based on a company’s financial constraints.  And it means appreciating that these parameters can be determined with the help of advisors such as an accountant, a banker or other financial professionals.

Once known, they can be managed and monitored to ensure that, in the good times; the business doesn’t flare up like a supernova only to extinguish without a trace, but rather remains a brightly shining star for millennia to come.

   
© 2006 NH SBDC
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