Growth is fundamental to human nature. The same principle applies to business. A decline in growth often indicates trouble in a business and, if not reversible, can mean the demise of the business. Entrepreneurs are largely measured by growth and are usually actively seeking to achieve maximum growth and gain as much market share as possible. If this growth is not managed properly, it can backfire and can hurt or even ruin a business financially.
For more than a decade, Ventex Corporation has observed and advised on the growth patterns of various companies. This case study focuses on two manufacturing companies in the same industry. Details are changed for confidential purposes; however, all the details simulate the real life scenarios close enough to demonstrate the actual learnings. The following points highlight the key figures for the two companies over a five-year period:
- Company A’s turnover grew from $78.9 million to $348.7 million. Company B’s turnover was more controlled and grew from $77.5 million to $178.9 million.
- Company A’s profit margins (net profit divided by turnover) decreased from 2.5% to 1.2%. Company B’s profit margin increased from 4.1% to 16.8% in the same period.
- Asset turnover (turnover divided by total assets) for both companies remained reasonably stable over time. It averaged 2.3 for company A and 1.9 for company B.
- Financial leverage (debt plus equity divided by equity) was 19.1 in the first year for Company A and dropped to 12.3 in the fifth year. By comparison, Company B had financial leverage of 3.0 in the first year and it dropped to 1.6 in the fifth year.
- Company A returned all profits to the business, except for year three, when the retention rate was 74%. Company B had a 100% retention rate for the entire period.
- The sustainable growth figures showed that Company A could grow to a maximum of $301.7 million in the fifth year (they grew to $348.7 million) and Company B to $184.3 million (they grew to $178.9 million).
Both companies were analyzed in detail. One of the most important insights came from using the basic sustainable growth rate (SGR) formula formulated by Hewlett-Packard:
SGR = ROE*r where:
SGR = sustainable growth rate
r = retention ratio (1 – dividend payout ratio)
ROE = net profit margin * asset turnover * equity multiplier (financial leverage)
The sustainable growth rate is based on the previous year’s figures. If there is a deficit (actual turnover is greater than the target turnover based on the sustainable growth formula) for long periods of time, it is very likely that a company will run into financial problems and even go bankrupt. This is exactly what happens with Company A. By contrast, Company B grew below its sustainable growth rate and kept its financial position intact and became a very strong player in its industry.
What were the differences between these companies? Both companies started with similar billings ($78.8 million vs. $77.5 million). Four important differences are evident when analyzing the companies:
- Company A has a much lower profit margin than Company B (1.4% on average per year compared to 10.4%). Company B’s profitability actually increased over time. Further analysis showed that Company A undercut prices and quite often engaged in unprofitable deals to gain market share. Its gross profit margins were on average below 20% compared to more than 30% for Company B. Company B often steered clear of bad deals and focused on selling its products on the basis of its marketing services. value added.
- Company A financed its growth with extremely high debt compared to Company B (11.3 times financial leverage on average per year compared to 2.2 times). Further analysis of Company A revealed that the initial financial leverage of 19.1 times was not sustainable and the company later sold shares to finance growth and reduce the debt ratio. This turned out not to be enough and eventually high debt levels came back to haunt them. In contrast, Company B used less debt and nearly halved its financial leverage over the period. They are extremely liquid and solvent today.
- Company A paid a 26% dividend in the third year. This made a critical difference at that stage. Further analysis showed that they could actually have a surplus (actual turnover minus projected turnover based on the sustainable growth rate) in the fourth year of $3.3 million instead of a deficit of $7.8 million. Company B invested all its profits in the business and then reaped it. Further analysis revealed that its expenses (including director/shareholder salaries) were much lower relative to those of Company A.
- In the final analysis, Company A consistently grew faster than it could afford. By the fifth year, they had billings of $348.7 million, giving a deficit of $47 million. They were unable to finance this additional deficit and it led to their eventual demise. By comparison, Company B grew to $178.9 million in the fifth year; this is $5.4 million below its target billing based on its sustainable growth rate. The company could easily afford this growth.
A detailed analysis showed many other differences between the two companies. Company A’s strategy turned out to be one of uncontrollable growth, lack of financial discipline, unnecessary risk, early profit-taking, and lack of focus. The company was eventually liquidated.
For its part, Company B opted for a strategy of controllable and sustainable growth, strict financial discipline, limited risk and focus on profitable businesses. Today the company is recognized as a market leader in its industry and its harvest potential is excellent with many international players already showing great interest in acquiring the business.