Equity Multiplier Formula Using Return On Assets And Total Equity Business Growth – Grow Sustainably Or Go Bankrupt

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Business Growth – Grow Sustainably Or Go Bankrupt

Growth and managing growth pose special problems in financial planning. Growth is not always a blessing. Many companies are in financial crisis, have cash flow problems or even go bankrupt when they have a full order book. There can be many reasons for this phenomenon. A major reason, however, is the fact that companies grow too fast to support their strategic financial resources.

High turnover includes high assets in the form of stocks, debt and fixed assets. In order to achieve a sustainable growth rate these assets need to be financed through financial resources that are generated by the company or can be accessed by the company. Therefore, the biggest constraint to sustainable development is the ability to generate enough capital to finance the increase in assets (increase in working capital requirements). Non-financial resources that need to be developed sustainably include the company’s systems as well as the skills and experience of its employees.

The importance of growth

Growth is essential for a company’s survival. Strategically the company should grow to increase its market share and gain a competitive edge against competitors. Other important benefits of growth are company assets that can be better utilized, economies of scale, and increased profitability. In the final analysis growth is very important to put the company in an optimal position for harvesting purposes.

Determinants of sustainable development

Sustainable growth depends on the rate at which a company can generate funds and utilize these funds effectively. The maximum rate at which a company can increase its sales without draining its financial resources is called the sustainable growth rate. Key determinants of sustainable growth are rate of return, financial leverage, dividend policy and external equity.

  • Rate of return – The rate of return achieved by the company forms the basis of how fast the company can grow. A company’s profit margin (after taxes) multiplied by asset turnover (total assets divided by sales) gives the company’s return on assets or rate of return (ROA).
  • financial benefits – A company often uses debt to leverage a fixed rate of return (ROA) to achieve a much higher return on equity (ROE).
  • Dividend Policy – A company’s dividend policy is an important variable in manipulating sustainable growth rates. A dividend payout of 50% allows a company to grow half as fast as a similar company without paying any dividends.
  • External Equity – External equity is the most expensive form of development financing and dilutes shareholder returns. External equity should only be used as a final source of financing for the company.

An example of sustainable development.

Various sustainable growth rate formulas exist. Some of them analyze many details and take into account inflation, interest rates, external equity and various components of the business. A basic formula (created by Hewlett-Packard) that is very useful is:

SGR = ROE*r

Where:

SGR = Sustainable Growth Rate

r = retention ratio (1 – dividend payout ratio)

ROE = Net Profit Margin * Asset Turnover * Equity Multiplier

The above formula takes into account the company’s rate of return, financial leverage and dividend policy. It is based on the following premises:

  • It is not practical (or possible) to issue more shares (diminished equity).
  • The company is effectively managed and profit margins and asset turnover are at optimal levels.
  • Dividend payout is at a minimum level to facilitate the shareholders. If we take a company with the following performance indicators:
  • The debt/equity level is at an optimal level considering the company’s risk profile.

If we take a company with the following performance indicators:

  • Turnover (sales) – $100 million
  • Net profit (after tax) – $8 million
  • Equity – $20 million
  • Net worth – $50 million
  • Dividend payout – 0.4 (40%).

Therefore:

  • Net profit margin = 8/100 = 8%
  • Asset turnover = 100/50 = 2
  • Financial leverage = 50/20 = 2.5
  • Retention ratio = 1 – 0.4 = 0.6

The sustainable growth rate is:

SGR = ROE*r

= (8%*2*2.5*0.6)

= 24%

This means that this company can increase its sales by a maximum of 24 percent if it uses all its internal financial resources effectively. Thus the company’s turnover can increase from $100 million to $124 million. If the company grows faster than 24% with its current parameters then it is actually creating cash flow problems and it may eventually go bankrupt.

How can the company grow faster?

If a company wants to grow faster than their sustainable growth rate indicates and they don’t want to dilute their equity, they need to generate additional finance through one or more of the following:

  • High profitability – This can be achieved by several factors such as high gross margins and low expenses.
  • Better asset management – ​​This can be achieved by generating more sales and profits in relation to assets and reducing stock levels and days owed.
  • High Retention Ratio – The majority of profits are plowed back into the business.
  • High Debt Ratio – Asset expansion is financed by debt.

summary

Growth is crucial for any company to survive, gain market share, gain a competitive edge and position itself for harvest. Uncontrolled growth, however, is just as harmful as too little growth and can cause serious strain on a company’s cash flow and even bankruptcy.

However, the company’s management can scientifically analyze the company’s maximum sustainable growth rate using financial ratios and models. If the determinants of the company can be managed more effectively, the sustainable growth rate of the company can be increased.

Sustainable growth should be an integral part of any company’s strategy and should be managed professionally.

Copyright © 2008 by Wim Venter. All rights reserved.

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