Some time ago, I worked with a formula called the sustainable growth rate model. Generally, it takes a company’s profit margins, the amount it wishes to retain for growth (as opposed to pay out as compensation to management or dividends to investors) and compares this amount to the projected net assets required to support growth. It also factors in the company’s leverage ratio – how much it finances through debt versus equity.
For those of you who haven’t thought in mathematical equations since being tested on them at the end of the semester (myself included), let me try to put that in plain English. Generally, the after tax profit margin minus dividends paid out to shareholders leaves capital available for growth. Every dollar of growth requires so much capital to support it. Depending upon the life cycle of the company, this may be made up of funds for working capital (accounts receivable for example), or it may be capital expenditures for capacity expansion. Whatever the specific make up, the point is that there is a certain amount of growth a company can support based upon internally generated funds. Further, most companies operate with a certain ratio of debt and equity (as a company grows, it can generally support more debt). Growth beyond that must be supported by additional outside capital either by issuing new equity or increasing the leverage of the firm. Whether the company chooses to fund expansion with debt or equity will determine the amount of leverage and therefore financing risk that the business takes on.
Obviously, just because a formula determines a growth rate doesn’t mean a company can actually grow at that rate. Market and competitive factors as well as the company’s management team are critical factors. The formula is simply meant to suggest the maximum rate at which the company can grow given certain financial assumptions.
The rate at which a company grows and how it chooses to finance its growth, however, is an issue that every company must deal with one way or another. Either they choose to grow with internally generated capital, to issue new equity, to borrow to fund growth, or ultimately not to grow beyond their comfort zone. Some companies spend time thinking about these issues during their strategic planning process. Others may simply operate within their comfort zone which is an implicit decision about leverage, growth and risk tolerance guided by the ownership/management group.
If you believe you have growth opportunities ahead of you, it’s worth spending some time working through various growth assumptions and how those might be financed over both the short and long term.
If your business could benefit from fractional CFO services, I would welcome the chance to speak with you. Please give me a call at (314) 863-6637 or send an email to
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