What Is The Formula To Back Out Sales Tax Business Growth – Grow Sustainably Or Go Bankrupt

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Business Growth – Grow Sustainably Or Go Bankrupt

Growth and growth management present special problems in financial planning. Growing up is not always a blessing. Many companies are in financial trouble, have cash flow problems or go bankrupt with full order books. There are many reasons behind this issue. One of the main reasons, however, is that companies are growing too fast for their strategic financial resources to support them.

High income includes high assets in stock, debtors and fixed assets. To achieve a sustainable growth rate these assets must be financed by the financial resources that the company generates or has access to. The biggest constraint, therefore, for sustainable growth, is the ability to generate enough cash to support the increase in assets (increase in operating needs). Non-financial resources that also require sustainable growth include the company’s processes as well as the skills and experience of its employees.

The Importance of Growth

Growth is essential for a company to survive. Strategically the company needs to grow to increase its market share and reach a competitive level with its competitors. Other important advantages of growth are the company’s assets that can be optimally used, the economies of scale that occur and the profits that can be increased. In the final analysis growth is very important to position the company in the right place for harvesting purposes.

Constraints to Sustainable Growth

Sustainable growth depends on the speed at which the company can make money and use this money effectively. The maximum rate at which a company can increase sales without reducing its financial resources is called the sustainable growth rate. The main determinants of sustainable growth are the rate of return, financial strength, dividend policy and external equity.

  • Rate of Return – The rate of return earned by the company forms the basis of how fast the company can grow. The ratio of a company’s income (after taxes) multiplied by the return on assets (sales divided by total assets) gives the company’s return or return on assets (ROA) ratio.
  • Financial Status – A company often uses debt to increase its rate of return on equity (ROA) to achieve a higher return on equity (ROE).
  • Partition policy- The company’s dividend policy is the most important change in managing the sustainable growth rate. A dividend payout of 50% allows the company to grow half as fast as a similar company and no dividends are paid.
  • Foreign justice – External equity is the most expensive form of growth financing and reduces shareholder returns. External equity should only be used as a last resort to finance the company.

An Example of Sustainable Growth.

There are different approaches to sustainable growth. Some of them analyze a lot of data and take into account inflation, interest rates, stocks and various parts of the business. A basic formula (created by Hewlett-Packard) that is very useful is:

SGR = ROE*r

where:

SGR = sustainable growth rate

r = retention ratio (1 – dividend payout ratio)

ROE = net income * return on assets * multiple of equity

The above formula takes into account the rate of return, financial strength and the company’s dividend policy. It is based on the following areas:

  • It is not possible (or possible) to issue more shares (dilute equity).
  • The company is well managed and the profit margin and asset turnover are at reasonable levels.
  • The dividend payment is at the lowest level to keep the shareholders comfortable. If we take a company with the following performance indicators:
  • The debt/equity level is at an optimal level considering the risk profile of the company.

If we take a company with the following performance indicators:

  • Sales (sales) – 100 million dollars
  • Net profit (after tax) – 8 million dollars
  • Equity – $20 million
  • Total assets – $50 million
  • Dividend payment – 0.4 (40%).

Therefore:

  • Optimum Profit Margin = 8/100 = 8%
  • Current Assets = 100/50 = 2
  • Financial Leverage = 50/20 = 2.5
  • Storage size = 1 – 0.4 = 0.6

The sustainable growth rate is:

SGR = ROE*r

= (8%*2*2.5*0.6)

= 24%

It means that if this company uses all sources of internal funds effectively it can grow and sell a maximum of 24%. The company’s revenue may increase from 100 million to 124 million dollars. If the company grows faster than 24% with its current parameters it really creates cash flow problems and this can lead to the end.

How can a company grow quickly?

If a company wants to grow faster than it shows sustainable growth and they don’t want to reduce their equity they should make more money by one or more of the following:

  • Higher profits – this can be achieved through many factors such as higher gross margins and lower expenses.
  • Better asset management – this can be achieved by creating more sales and profits in relation to assets and reducing stock levels and debt days.
  • High retention rate – most of the income is transferred back into the business.
  • High debt ratio – asset expansion is heavily supported by debt.

Summary

Growth is very important for any company to survive, gain market share, gain competition and position itself to harvest. Uncontrolled growth, however, is as dangerous as too low growth and can put significant pressure on a company’s cash flow and can lead to bankruptcy.

Company management is able, however, to scientifically analyze the company’s most sustainable growth rate through the use of financial ratios and models. The sustainable growth rate of a company can be increased if its conditions can be managed properly.

Sustainable growth should be part of any company’s strategy and should be managed smartly.

Copyright © 2008 by Wim Venter. ALL RIGHTS RESERVED.

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