Jul 4, 2010

Calculating sustainable growth

Calculating sustainable growth
By Ian Rusk
Growth in revenue and earnings is probably the most common measure of a company's success. Growth enhances stock value, increases returns to shareholders, and creates advancement opportunities for employees. Nowhere is this more obvious than in the public stock market, where firms that fail to meet growth forecasts frequently see their stock values plummet. Because of this, in our roles as managers we tend to spend a great deal of time seeking out new business opportunities and making short- and long-term projections for revenue growth. Frequently, however, we focus solely on the market side of the growth equation and ignore the internal constraints on growth.
The old adage "it takes money to make money" applies as much to the A/E/P and environmental consulting industries as any other line of business. Growth requires capital, or more specifically, cash. This is a simple function of the fact that before we can collect payment from our clients, we must invest in the costs of delivering the products or services we sell. That includes labor costs (employees salaries, benefits, payroll taxes, etc.), overhead costs (rent, utilities, office supplies), and capital investments (computers and other equipment, office furniture, etc.). As a firm grows, so does the size of this investment, and the firm's ability to fund that investment is an internal constraint on growth.
This leads us to the question of just how much growth a firm can sustain, without the need to raise additional equity capital or increase debt levels. This maximum rate of internally funded growth is defined as the Sustainable Growth Rate (SGR).
Pick up three finance text books, and you'll probably find three different formulas for calculating SGR. But the underlying concept is the same. The maximum rate of sustainable growth depends on four primary factors:
Profitability: Obviously, the higher the firm's profit margins, the more cash flow it can generate from operations. And the more cash it generates from operations, the more it can invest in growth.
Asset Requirements: Another factor affecting a firm's ability to generate cash flow from operations is how quickly it can convert work-in-progress into accounts receivable, and how quickly it can collect those receivables. The faster work-in-progress (WIP) and accounts receivable (A/R) can be converted to cash, the better cash flow will be. Conversely, the slower WIP and A/R are collected, the greater the investment needed to fund growth will be. In addition, firms that require more fixed assets (equipment, vehicles, etc.) to perform their services will also require greater investment in assets in order to grow. This required asset level is measured by the ratio of total assets to sales.
Financial Leverage: Debt is a potential source of funding for a growing company. Typically, when calculating a firm's sustainable growth rate, we hold the current debt to equity ratio constant. That is, we assume debt and other liabilities will increase at the same rate as equity. However, it's important to note that a firm with very low financial leverage (debt/equity) has the ability to grow at a faster rate by increasing their relative debt levels.
Earnings Retention Rate: This is the opposite of the firm's dividend payout ratio. It represents the percentage of earnings the firm retains or reinvests, as opposed to distributing to shareholders via dividends or S-distributions. The higher the amount retained by the firm, the higher its sustainable growth rate. As with debt levels, this is a ratio that is held constant when calculating the sustainable growth rate, but it's also a factor that can be adjusted by management to increase growth capacity.
Now that we understand the factors affecting sustainable growth, how do we go about calculating it? Let's look at one popular formula for SGR. But first we need to define how we'll measure the factors outlined above:
Profitability (P): We'll define profitability as the net profit margin, or net income (after taxes) divided by net service revenue.
Asset Requirements (A): The asset requirement factor will be measured by the ratio of assets to net service revenue (total assets/NSR).
Financial Leverage (L): Here we will use the ratio of liabilities to equity (total liabilities/equity).
Earnings Retention Rate (R): We define this as the percentage of net income retained by the firm vs. being paid out as dividends or S-distributions.
Using these factors, the sustainable growth rate is calculated as follows:
SGR = [P x R x (1 + L)] / [A – (P x R x (1 + L))]
To illustrate this, let's use the example of a hypothetical A/E firm XYZ Architects & Engineers, Inc. The firm had net service revenue last year of $10 million. Its net after tax income was $500,000, or 5%. Of that amount, it paid 70% out to shareholders and retained 30%. Its assets totaled $5 million, with total liabilities of $3 million and equity of $2 million. Therefore its financial leverage factor is 1.5, and its asset to net service revenue ratio is 0.5. The sustainable growth rate is:
SGR = [.05 x .30 x (1 + 1.5)] / [.50 – (.05 x .30 x (1 + 1.5))] = 8.1%
This means that without raising additional equity or debt capital, and assuming asset requirements remain the same, XYZ Architects & Engineers will only sustain a growth rate of 8.1%.
If the firm's business plan and forecasts predict faster rates of growth, then additional sources of capital will be needed. The firm's options might include raising new equity capital (issuing and selling new shares of stock). It could increase its financial leverage (by borrowing more or extending trade payables if possible). Also, it might be able to reduce its asset requirements by finding ways to speed up its average collection period.
Theoretically, cutting expenses, thereby increasing the net profit margins, and reducing the dividend payout rate would also allow for higher sustainable growth rates. However, each of these measures could negatively impact the firm's ability to grow. Often achieving growth requires increased spending, such as marketing expenses, or expenses related to recruiting and hiring the necessary staff. Cutting back on such overhead costs can stifle actual growth, whatever the firm's maximum sustainable growth rate may be. And reducing payouts to shareholders can make the stock less attractive as an investment, thereby making it more difficult to raise new equity capital.
The sustainable growth rate may seem at first like an esoteric financial theory, but hopefully you can see from the example above that it can be a useful and revealing analytical tool.

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