For Determination Of Cost Of Equity The Formula Used Is Business Growth – A Case Study on Good Vs Bad Growth

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Business Growth – A Case Study on Good Vs Bad Growth

Evolution is central to human nature. The same principle applies to business. A decline in growth often indicates problems in the business and if not reversed could mean the death of the enterprise. Entrepreneurs are largely measured on growth and they usually actively set out to maximize growth and gain as much market share as possible. If this growth is not managed properly it can be counter productive and can financially harm or ruin the company.

For more than a decade, Ventex Corporation has observed and advised on the growth patterns of many companies. This case study focuses on two manufacturing companies in the same industry. Details have been changed for confidentiality purposes – however, all details mimic real-life scenarios sufficiently to demonstrate real learning. The following points highlight key figures for the two companies over a five-year period:

  1. Company A’s turnover increased from $78.9 million to $348.7 million. Company B’s turnover was more controlled and increased from $77.5 million to $178.9 million.
  2. Company A’s profit margin (net profit divided by turnover) fell from a low of 2.5% to 1.2%. During the same period, the profit margin of Company B increased from 4.1 percent to 16.8 percent.
  3. Asset turnover (turnover divided by total assets) was reasonably stable over time for both companies. It averaged out to 2.3 for Company A and 1.9 for Company B.
  4. Financial leverage (divided by debt and equity equity) for Company A was 19.1 in one year and it came to 12.3 in five years. In comparison, Company B’s profitability was 3.0 in one year and it came to 1.6 in five years.
  5. Company A kept all profits back into the business, except for three years when the retention ratio was 74%. Company B had a retention ratio of 100% for the entire period.
  6. The sustainable growth figures show Company A making the most over five years at $301.7 million (they grew to $348.7 million) and Company B at $184.3 million (they grew to $178.9 million).

Both companies were analyzed in detail. One of the most important insights came from the use of the basic sustainable growth rate (SGR) formula developed by Hewlett-Packard:

SGR = ROE*r Where:

SGR = Sustainable Growth Rate

r = retention ratio (1 – dividend payout ratio)

ROE = Net Profit Margin * Asset Turnover * Equity Multiplier (Financial Profit)

The sustainable growth rate is based on the previous year’s data. If there is a deficit (actual turnover is greater than the target turnover based on the sustainable growth formula) over an extended period the chances of the business going into financial distress and bankruptcy are very good. This is exactly what happens at Company A. In contrast Company B grew below their sustainable growth rate and they kept their financial position intact and became a very strong player in their industry.

What was the difference between these companies? Both companies started with similar turnover ($78.8 million vs. $77.5 million). Four important differences are evident from the analysis of the companies:

  1. Company A has a much lower profit margin than Company B (1.4% on an average annual basis compared to 10.4%). Company B’s profits actually increased over time. Further analysis proved that Company A cut prices and often ran unprofitable businesses to gain market share. Their gross profit margins averaged less than 20% compared to over 30% for Company B. Company B usually avoids bad business and focuses on selling their products based on their value added services.
  2. Company A financed its growth with significantly higher debt compared to Company B (11.3 times financial leverage on an average annual basis compared to 2.2 times). An in-depth analysis of Company A showed that the initial financial leverage of 19.1 times was unsustainable and the company subsequently sold equity to drive down financial growth and debt ratios. This did not prove to be enough and eventually high debt levels came to haunt them. In contrast Company B used less debt and they nearly halved their financial leverage over the period. They are extremely liquid and solvent today.
  3. Company A paid a dividend of 26% in year three. It made a significant difference at that stage. Further analysis showed that they could actually have a surplus (actual turnover minus target turnover at constant growth rates) of $3.3 million over four years instead of a loss of $7.8 million. Company B reinvested all their profits back into the business and they subsequently made a profit. Further analysis actually revealed that their expenses (including salaries to directors/shareholders) were much lower than Company A’s.
  4. In the final analysis Company A grew faster than they could. For five years they had a turnover of $348.7 million – this led to a loss of $47 million. They could not fund this additional deficit and this lead to their eventual demise. By comparison Company B grew to $178.9 million over five years – this is $5.4 million under their target turnover according to their sustainable growth rate. The company can easily afford this increase.

A detailed analysis revealed several other differences between the two companies. Company A’s strategy proved to be one of uncontrolled growth, lack of financial discipline, unnecessary risk, premature profit taking and lack of focus. The company was eventually liquidated.

Company B, on the other hand, has chosen a strategy that focuses on controllable and sustainable growth, strict financial discipline, limited risk and profitable business. Today the company is recognized as a market leader in its industry and their harvesting capacity is excellent with many international players who have already shown keen interest in acquiring the business.

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