FINANCIAL LIMITS TO GROWTH

By Paul Winters

If you are the owner or manager of a business, one of the tasks you frequently face is reading your financial statements. Do your eyes glaze over as you look at page after page of numbers that are supposed to be conveying important information to you? Are you presented with endless ratios and percentages and confused over what to do with them?

You are not alone in your dilemma!! When you started the business, you knew exactly what was important to your survival---satisfied customers and enough cash to pay your bills on a current basis. Success at those two items generally meant your business was also profitable. You were involved with most aspects of the business and made daily decisions on detail transactions that affected the profitability of the company.

If your business is typical of other successful businesses, it had the audacity to change. It grew! And with that growth came the complexity of managing it.

Surprise! Along with all of the positive changes came the need to use financial statements as a management tool. If you are typical of most owners, your expertise and background is not in the financial area. Your reading of financial statements is probably limited to review of net income, gross profit and current ratio. Unless those numbers are not meeting your expectations, interpretation of the rest of the statements is left to the smiling accountant.

I am not going to attempt to educate you in all of the intricacies and secrets buried in those statements. Many volumes have been written on the subject. And I certainly don't want your eyes to glaze over while you read this.

But, with those statements in hand and a few assumptions about your company's operating characteristics and financial policies, you can solve a puzzling question facing small, rapidly growing companies. HOW FAST CAN I GROW? In his book, A Manager's Guide to Financial Techniques, George Aragon presents a simple formula to compute your maximum sustainable growth rate. He states that, "Just as there are capacity constraints on a company's output growth, and just as there are market share constraints on sales growth opportunities, so too are there financial limitations to sales expansion."

The financial limits can be estimated as follows:

G = (M x R x L) divided by A - (M x R x L) where:

G = Maximum sustainable growth rate in assets and sales

M = Profit margin on sales (Net income / Net Sales)

R = Percentage of net income retained in the business (i.e., not used for dividends to stockholders)

L = Debt/Equity ratio plus 1.0

A = Assets/Sales ratio

Now I know that this looks like a complicated formula, but, if you compute each of the factors individually, the formula is a simple algebraic computation. To keep the formula simple, it assumes that no new equity will come into the company and that the company is profitable.

Now what does it mean. Assuming the computed growth rate is 8.5%. If your company attempts to grow at 11% the company will experience diminishing liquidity. Suddenly, cash evaporates with all the resultant problems of meeting payrolls, vendor payment terms and debt servicing. Conversely, if the company grows at a slower rate, say 6%, excess liquidity will build up.

With knowledge of your company's inherent financial limit to growth, you can plan your future to stay within those limits. Or, make changes to the financial characteristics that are limiting your growth.