How much a firm can grow
Sustainable Growth Rate: How much a firm can grow
A company requires capital to finance the growth. This can be achieved by using internally generated funds, or by issuing new equity shares. But, it has been observed that companies show reluctance in issuing new equity to raise capital (Firer, 1995, p-57). Without recourse to new equity capital, there is a limit to the growth of the company. The company can grow without opting for external equity finance by altering its present financial structure.
Sustainable Growth Rate and its Importance
There exists an important relation between growth in sales, and increase in assets and equity. Rapid sales growth requires additional assets such as equipment, plants, inventories and account receivables. If the company does not have sufficient funds, it cannot accelerate its sales growth. There are many cases where rapid growth has led profitable companies into financial distress and in some cases even to bankruptcy. On the other side, companies that grow slowly have unutilized cash making them uncompetitive. Robert C. Higgins introduced the sustainable growth rate model in 1977. The sustainable growth can be described as the maximum rate of growth that a company can sustain without borrowing more money or increasing financial leverage (Higgins, 1977, p-7). It has emerged as a useful in the hand of managers for determining whether the company’s target growth rate can be achieved from retained earnings or recourse to external financial sources will be necessary (Kijewska, 2016, p-139).
Sustainable Growth Rate Equation
Where
p is profit margin after taxes; d is target payout ratio; L is target debt to equity ratio;
t is total asset to net sales ratio; s is sales at the beginning of year; delta ( ) s is increase in sales during the year.
We take financial figures for 1st quarter of 2014 for calculations (Quarterly Financial Report, 2015, Table-1, p-2). Profit margin = 8.34%, payout ratio = 42.65% , debt to equity ratio = 56.82%, asset to sales ratio = 1.35. Putting these values in the equation, we get sustainable growth rate = (0.0834)(1-0.43)(1+0.57)/ {1.35-(0.0834)(1-0.43)(1+0.57)} = 0.075/ 1.27 = 5.86%
Consequence of too fast or too slow growth and Available Alternatives
A company growing at a rate that is below the sustainable growth rate has more than enough capital to meet its investment requirements. In the long run, this company will become uncompetitive and its survival may be threatened. The company can adopt a two-pronged approach to protect from suboptimal growth. First, the company requires to find out whether market conditions permit further growth. If so, the company needs to invest in the capital equipment and increase capacity to capture growth in the existing market. If this alternative is not feasible, the company may consider diversification through new investments in product development or it can explore merger and acquisition route to buy growth. In case, the company finds these opportunities unattractive, it should return excess cash to shareholders through dividends or share repurchases line or pay off existing debt (Sampath, R. & Kambil, 2005, p-2).
As already discussed, a company can grow at a high rate, but this is not sustainable in the long run. Its finances will come under stress and it will unable to meet its stated financial objectives. To cope with the actual growth rate in excess of the sustainable level, a company may explore the alternative of issuing new equity shares. Most of the companies do not prefer this route to raise capital due to the high cost associated with raising new equity, undervaluation of equity and loss of voting control. Another option is relaxing financial constraints by allowing payout ratio to decline and debt to equity ratio to rise. Drawback associated with these measures is increased risk and reduction in cash flow to shareholders. The company may increase profitability by increasing sales price or eliminating some services accompanying sales. These measures may affect sales in the long run (Higgins, 1977, pp-14-15). The company can also explore restructuring its business by selling off its product lines with modest growth prospect.
Conclusion
The sustainable growth rate model introduced by Higgins has been further enriched by the development of different models. These models have further strengthened the utility of the sustainability growth rate as a financial tool to gauge whether the firm’s future growth plans are realistic based on its current performance and policy. By combining company’s operating and financial elements into one comprehensive measure, it allows managers to analyze and explore for opportunities (Sampath & Kambil, 2005, p-1).
References
Firer, C. (1995). Investment Basics: XXXI. Sustainable Growth Models. Investment Analysis Journal, 41 (Winter), pp-57-58. Retrieved Aug.24 2016, from http://www.iassa.co.za/articles/041_win1995_06.pdf
Higgins, R.C. (1977). How Much Growth Can a Firm Afford?. Financial Management, 6(3), p-7-16. http://www.jstor.org/stable/3665251
Kijewska, A. (2016) Conditions For Sustainable Growth (SGR) for Companies from Metallurgy and Mining Sector in Poland. Metalurgija, 55 (1), pp-139-142. Retrieved Aug.24 2016, from https://www.researchgate.net/publication/280233642_Conditions_for_ sust ainable_growth_SGR_for_companies_from_metallurgy_and_mining_sector_in_Poland
Quarterly Financial Report for Manufacturing, Mining, Trade, and Selected Service Industries. (2015, June). U.S. Census Bureau, Washington, DC. Retrieved Aug.24 2016, from http://www2.census.gov/econ/qfr/pubs/qfr15q1.pdf
Sampath, R. & Kambil, A. (2005). Sustainable Growth: Is There Room to Grow?. Deloitte Research, Deloitte Services LP. Retrieved Aug.24 2016, from www.deloitte.com/dtt/cda/doc/content/DTT_DR_Sus-Growth_nov05.pdf
