Growth rates mark the ambition and drive the valuation of any business. They are very important yet hard to get right. Very few companies achieve growth of both sales and profits; many will achieve a growth in sales but profitability will remain flat or decline somewhat; and even more will contract or even close completely. One of the sad facts of entrepreneurship is that many SMBs that fail do so in their year of best sales. The reason: they have grown too quickly and have over-traded, leading to too much cash being locked-up in the working capital cycle and too little liquidity remaining. Something happens and the business takes a knock but doesn’t have the cash to roll with the punch and is liquidated. In even sadder cases the owner sets a growth target higher than is financially sustainable and the very sales people that achieve the target are unemployed within months.
Furthermore, when raising money or trying to sell the business all entrepreneurs will tell you how they expect their business to grow easily and rapidly, yet the astute lender/investor/buyer will need to interrogate how much growth is actually possible.
So how do we predict how fast a business will grow and can grow?
The reality is that predicting growth is very hard. Prior performance will give insight into what’s been achieved to date, however if you looked a prior performance v. prior forecasts its almost certain you’d see under-achievement by the business relative to earlier expectations (you’d be lucky to find this information of course: it’s not something management are normally proud of).
We can follow a top-down process to predicting the growth rate of a firm: start with the country’s growth rate. Then compare the expected growth rate for the industry. Is there any reason why the industry itself will grow faster or slower than the country? Then speak to your suppliers to understand how fast they expect to grow. Why? What about your customers: how fast do they expect to grow and will you receive your expected ‘share’ of that growth? If one keeps objective through this process (and if you repeat it quarterly) you’ll quickly get to a range of believable numbers and a clear thesis as to why they’re believable. You’ll have a range of growth forecasts with a lower (pessimistic) and higher (optimistic range).
As a first check, comparing these to the country’s inflation rate tells you immediately if real value is being created or destroyed, but can the firm actually achieve this growth?
The ‘Sustainable Growth Rate (“SGR”) is a very useful concept developed by Robert Higgens. It describes optimal growth from a financial perspective assuming a given strategy with clear defined financial frame conditions/ limitations. Sustainable growth is defined as the annual percentage of increase in sales that is consistent with a defined financial policy (target debt to equity ratio, target dividend payout ratio, target profit margin, target ratio of total assets to net sales). In other words, the SGR for any firm depends on your capital structure, dividend payout ratio, profit margins, and asset utilisation – changing any of these has an impact on the amount of growth your firm can achieve. Here is the formula:
SGR = (pm*(1-d)*(1+L)) / (T-(pm*(1-d)*(1+L)))
- pm is the existing and target profit margin
- d is the target dividend payout ratio
- L is the target total debt to equity ratio
- T is the ratio of total assets to sales
Putting this into practice: get your partners/senior management to come up with optimistic and pessimistic growth forecasts for your firm, preferably for each product line/market/region and customer. Look closely at the ones where opinions vary widely and try to understand what drives those differences. Arrive at your growth target for the next financial year. Compare this to inflation (about 5.6% in South Africa). Then take your most recent financial statements and calculate the SGR using the formula above.
If your growth targets/expectations are above your SGR, then you’ll need to invest more equity capital, reduce dividend payouts, increase financial leverage or increase your target profit margin. If you don’t do this you may still achieve your desired growth, but it will be unsustainable and depending on the strength of your balance sheet there is a good chance you’ll be desperately hunting for cash (and survival) within a few months.
Conversely, if you expected growth is well below the SGR, then there is potential to reduce leverage or increase dividends (your preference) without risking the potential of the business. Some simple playing around with your inputs to your SGR calculation will greatly help you understand how much growth is realistic for your firm.
This is crucial information for management, for sales teams, for investors/funders and for the buyers of any business…don’t set (or accept) targets without it.