Growth is fundamental to human nature. The same principle applies to businesses. A decline in growth often indicates problems in a company and, if it is not reversible, it can mean the demise of the company. Entrepreneurs are largely measured by growth and are typically actively pursuing maximum growth and gaining as much market share as possible. If this growth is not managed properly, it can backfire and can damage or even financially ruin a business.
For more than a decade, Ventex Corporation 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 details simulate real life scenarios close enough to demonstrate 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) of 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 year one for Company A and dropped to 12.3 in year five. By comparison, Company B had financial leverage of 3.0 in the first year and down to 1.6 in the fifth year.
- Company A returned all profits to the business, except in the third year, when the withholding rate was 74%. Company B had a 100% retention rate for the entire period.
- Sustainable growth figures showed that Company A could grow to a maximum of $ 301.7 million for Year Five (grew to $ 348.7 million) and Company B to $ 184.3 million (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 that was formulated by Hewlett-Packard:
SGR = ROE * r where:
SGR = sustainable growth rate
r = retention ratio (1 – dividend payment ratio)
ROE = net profit margin * asset turnover * capital multiplication (financial leverage)
The sustainable growth rate is based on the previous year’s figures. If there is a deficit (the actual turnover is greater than the forecast turnover based on the sustainable growth formula) for long periods, it is very likely that a company will be in financial difficulties and even go bankrupt. This is exactly what happens with company A. In 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 a similar turnover (78.8 million dollars versus 77.5 million dollars). Four important differences are evident when analyzing companies:
- Company A has a much lower profit margin than Company B (1.4% on an average annual basis compared to 10.4%). Company B’s profitability increased over time. Further analysis showed that Company A cut prices and often conducted 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 shied away from bad deals and focused on selling its products on the basis of its trading services. value added.
- Company A financed its growth with extremely high debt compared to Company B (11.3 times the annual average financial leverage compared to 2.2 times). A deeper analysis of Company A revealed that the initial financial leverage of 19.1 times was not sustainable and the company then 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 almost halved its financial leverage during the period. Today they are extremely liquid and solvent.
- Company A paid a 26% dividend in the third year. This made a critical difference at that stage. A more detailed analysis showed that they could actually have a surplus (actual turnover minus target turnover according to 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 reaped them later. A more detailed analysis actually revealed that their expenses (including director / shareholder salaries) were much lower relative to those of Company A.
- In the final analysis, Company A consistently grew faster than they could afford. By the fifth year they had a turnover of $ 348.7 million, which gave 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 turnover in accordance with 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 proved to be one of uncontrollable growth, lack of financial discipline, unnecessary risk, taking profit ahead of schedule, and lack of focus. The company was finally liquidated.
On the other hand, Company B chose a sustainable and controllable growth strategy, strict financial discipline, limited risk and a focus on profitable businesses. Today the company is recognized as a market leader in its industry and its collection potential is excellent with many international players already showing great interest in acquiring the business.