(Originally published in Inc Magazine.)
What typically tops the list of worries of the chief executive officers of fast growing companies? Financing that growth, according to surveys over the years. This is because many companies are growing faster than they can afford.
Your company is growing faster than it can afford if you must continually scramble to increase your debt-to-equity ratio, sell stock, liquidate assets, or take more drastic measures to finance your growth. But business life doesn’t have to be like that. It’s possible to grow at an affordable rate.
Speaking at an engineering conference more than 65 years ago, David Packard explained how the Hewlett-Packard Company maintained an affordable growth rate during its first years of fast growth.
From 1950 through 1957, Packard said, the company had increased its sales twelve-fold—without using any outside capital. HP maintained this 43% growth rate by using a financial formula to help it manage its growth.
This formula is what the firm calls its affordable growth rate. But because most business texts use the term sustainable growth rate (SGR), that’s the term I’ll use.
The SGR is a growth strategy based on two assumptions. The first is that your sales can grow only as fast as your assets. If yours is like most firms, for example, you can’t increase your sales by 30% unless you increase your receivables, your inventories, and your fixed assets by about 30% as well.
The second assumption is that your firm has a target debt-to-equity ratio, and that your lenders are willing to continue to extend credit at that ratio. This assumption implies that as your equity grows, debt can grow at the same rate, allowing you to maintain a constant debt-to-equity ratio.
The SGR can be determined easily be considering the effect of these assumptions on a fast-growing company that plans to double its sales yearly.
If sales are to double, assets must double (assumption 1). And since the balance sheet must balance, total debt and equity must double as well. Lenders will allow debt to double if equity doubles (assumption 2). Financing the growth rate of your firm’s sales, then, depends on the growth rate of its equity.
The SGR is equal to the annual percentage increase in the stockholders’ equity section of a firm’s balance sheet. The following display shows how the SGR can be expressed as a formula:
Let’s take an example. Suppose your company pays out 20% of its earnings in dividends. The retention ratio (b) is therefore 80%. (1.00 minus 20%); that is, your firm keeps 80% of its earnings. If your company maintains a return on beginning equity (R) of 30%, your sustainable growth rate is equal to 80% times 30%, or 24%.
Notice in the formula that the stockholders’ equity figure at the beginning of the period is used to calculate R. When you use balance-sheet data in any SGR formula, always use data from the beginning of the period. This is the same, of course, as using data from the year-end balance sheet of the previous period. The reason is that the SGR formula compares what you started with (the balance sheet) with what you did with it (the income statement).
What does an SGR of 24% mean? It means that if you maintain a growth rate of about 24%, your financial growth will stay in balance. A faster growth rate would force you to increase your debt ratio or sell more stock. A slower growth rate would allow you to reduce your debt ratio or buy your stock.
The SGR shows your firm’s financial ability to grow through performance. It’s important that you keep this calculation in perspective, however. As Packard told his audience, “In spending most of my time talking about the financial aspects of growth, I do not mean to imply that these are in any sense determining. The other things you do determine how fast you grow, provided you have the financial resources.”
Applying the Sustainable Growth Rate
Although the SGR formula does calculate your sustainable growth rate, it offers little insight if you wish to improve on that performance. An expanded version of the formula begins to offer that insight.
This formula shows that your sustainable growth rate is the product of your earnings retention ratio (A), a leverage ratio (B), your profit margin on sales (C), and the turnover of your assets (D).
These four ratios represent two types of components. Earnings retention and leverage, A and B, are decisions. Net profit margin and asset turnover, C and D, are results.
The decision components are statements of policy. They reflect the attitude that you, your investors, and your lenders take toward your company’s risks and opportunities.
The result components reflect the outcomes of managerial action – in other words, operating performance. The net profit margin indicates the market competitiveness of your firm, its operating efficiency, and your ability to control overhead costs.
Asset turnover measures the ability of assets to produce revenue. As Packard said in his speech, it measures the ability of the sales group to sell its products to customers who pay on time, the efficiency with which manufacturing uses its fixed assets, and the ability of the purchasing group to deliver raw materials to the plant when they are needed and not before.
Often, I’ll combine the two decision components and the two result components in an SGR formula. Since both decision components tend to be relatively stable over time, I often use a constant in the calculation, based on their actual values. I call this the Leverage Multiplier. The profit margin multiplied by the turnover is an overall measure of operating performance, called the Return On Assets (ROA).
To illustrate, HP maintained a retention ratio of about 90% and a debt-to-equity ratio of about 45% from 1975 to 1985. Its Leverage Multiplier is therefore 1.31 (90% times 1.45). HP could express its sustainable growth rate as:
SGR = 1.31. x ROA
I like this version of the SGR formula because it emphasizes the importance of operating performance to your firm’s financial ability to grow. Growth depends on operating performance, and the ROA reflects that performance.
How should you use these SGR formulas? Most frequently, I suspect, you will find them useful in your mental tool kit. With the SGR in mind, for example, you will know that your friend’s company, which has an ROA of 35%, must be generating a lot of cash if it is growing by only 20% a year.
You will also find the SGR to be useful during your planning and budgeting cycle. Calculating an SGR allows you to step back from the nitty-gritty details and determine the overall financial performance necessary to finance the expected growth rate of your sales.
But when you begin to apply these formulas to your own financial statements, you’ll probably encounter some difficulties. First, of course, if you’re losing money, you can’t very well grow through performance. You’ll need to get your business into the black before you can start thinking about a sustainable growth rate.
Another problem you may experience is that your financial ratios may jump around from month to month. What effect will these fluctuating ratios have on your SGR? “Now, obviously,” Packard said, “you cannot control all of these factors on a day-to-day basis or even a year-to-year basis to match this formula precisely. But it does tell you how fast you can grow without changing the ownership pattern, the debt structure, or any of the other basic characteristics of your business.
“Actually, you can deviate quite widely from this on a year-to-year basis,” Packard continued.
“For example, in our case, our profit has varied from 6% to 15%. The turnover has gone as high as seven times per year in years of very rapid growth, and on occasion it has gone below four times.”
Ratios like these are tough to achieve year after year. But such ratios are what fast-growing companies must maintain if they expect to sustain their growth rates.
Whether your firm is growing quickly or slowly, however, it must pay its own way over the long run. The SGR formula provides a convenient measure of your financial ability to support the growth rates of which we all dream.
Note: See Weighing Your Debt Load for more information about this topic.