How Fast Is Too Fast?
What tops the list of worries of the typical chief executive officer of an INC. 500 company? Business financing, according to an INC. survey ("What, Me Worry?" June, page 56).This year's INC. 500 class would probably agree, because chances are good that more than a few of them are growing faster than they can afford to.
Your company may be growing faster than it can afford to 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 is possible to grow at an affordable rate.
At an engineering conference nearly 30 years ago, David Packard explained in a speech, "Growth from Performance," how the Hewlett-Packard Co. maintained an affordable growth rate during its first years of fast growth. From 1950 through 1957, Packard said, the company had increased its sales twelvefold -- 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 today calls its affordable growth rate (AGR).
The AGR 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 AGR can be determined easily by considering the effect of these assumptions on an INC. 500 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). The growth rate of your firm's sales, then, depends on the growth rate of its equity.
The AGR is equal to the annual percentage increase in the stockholders' equity section of a firm's balance sheet. The box on the following page shows how the AGR can be expressed as a formula:
AGR = Earnings After Dividends / Beginning Stockholders' Equity
= Earnings After Dividends / Earnings X Earnings / Beginning Stockholders' Equity
= Earnings Retention Ratio X Return on Equity
AGR = bR
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 affordable 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 AGR 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 AGR formula compares what you started with (the balance sheet) with what you did with it (the income statement).
What does an AGR 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 AGR 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."
Although the formula does calculate your affordable growth rate, it offers little insight if you wish to improve on that performance. An expanded version of the formula (shown in the box, above right) begins to offer that insight.
This formula shows that your affordable growth rate is the product of your earnings retention ratio (I), a leverage ratio (II), your profit margin on sales (III), and the turnover of your assets (IV). These four ratios represent two types of components. Earnings retention and leverage, I and II, are decisions. Net profit margin and asset turnover, III and IV, are results.
[SEE ORIGINAL MAGAZINE]
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 manufacturing 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 AGR formula. Since both decision components tend to be relatively stable over time, I use a constant in the calculation, based on their actual values. I call this the decision 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 '85. Its decision multiplier is therefore 1.31 (90% times 1.45). HP could express its affordable growth rate as:
AGR = 1.31 X ROA
I like this version of the AGR 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 AGR formulas? Most frequently, I suspect, you will find them useful in your mental tool kit. When the AGR 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 AGR to be useful during your planning and budgeting cycle. Calculating an AGR 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 all, of course, if you're losing money, you can't very well grow through performance. You'll neet to get your business into the black before you can start thinking about an affordable 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 AGR? "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 then 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 even the slowest-growing company of the INC. 500 must exceed if it expects to sustain its present growth rate.
Whether your firm is growing quickly or slowly, however, it must pay its own way over the long run. The AGR formula provides a convenient measure of your financial ability to support the growth rates of which we all dream.
CORRECTION-DATE: February, 1987
In his article "Finance: How Fast Is Too Fast?" (December), Charles W. Kyd makes the question of financing growth much more complicated than necessary for small business.
We should recognize that the structure of a balance sheet remains relatively constant. For example, the ratio of inventory, receivables, and equipment to sales runs about the same year after year. With that in mind, here is a formula you can use: if the percentage increase in net worth is the same as the percentage increase in sales, then you will continue at the same relative comfort/discomfort level with your financial structure. If you want to increase the comfort level there are three things you can do: first, improve your profit percentage while maintaining your growth rate; second, lower your growth rate below the rate of increase in equity; or third, bring in new capital.