Business Growth – A Case Study on Good Vs Bad Growth

Growth is central to human nature. The same principle applies to business. A decline in growth often signals problems in a business and if not reversible it can mean the demise of the enterprise. Entrepreneurs are to a large extent measured on growth and they normally actively set out to achieve maximum growth and to gain as much market share as possible. If this growth is not properly managed it can be contra-productive and it can harm or even ruin a company financially.

Over more than a decade Ventex Corporation observed and advised on the growth patterns of several companies. This case study focuses on two manufacturing companies in the same industry. Details are changed for confidential purposes – all the detail do, however, simulate the real-life scenarios close enough to demonstrate the actual learnings. The following points highlight the key figures of the two companies over a five-year period:

  1. 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.
  2. Company A’s profit margins (net profit divided by turnover) declined from a low 2.5{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b} to 1.2{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b}. Company B’s profit margin increased from 4.1{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b} to 16.8{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b} in the same period.
  3. Asset turnovers (turnover divided by total assets) for both companies were reasonably stable over time. It averaged out at 2.3 for Company A and 1.9 for Company B.
  4. Financial leverage (debt plus equity divided by equity) was 19.1 in year one for Company A and it came down to 12.3 by year five. In comparison Company B had a financial leverage of 3.0 in year one and it came down to 1.6 by year five.
  5. Company A put all the profits back in the business, except for year three when the retention ratio was 74{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b}. Company B had a retention ratio of 100{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b} for the whole period.
  6. Sustainable growth figures showed that Company A could grow to a maximum of $301.7 million by Year Five (they grew to $348.7 million) and Company B to $184.3 million (they grew to $178.9 million).

Both the companies were analysed in detail. One of the most important insights came from the use of 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 payout ratio)

ROE = net profit margin * asset turnover * equity multiplier (financial leverage)

The sustainable growth rate is based on the figures from the previous year. If there is a deficit (actual turnover is greater than targeted turnover based on the sustainable growth formula) over extended periods the chances are very good that a business runs into financial distress and even goes bankrupt. This is exactly what happens with company A. In contrast Company B grew below their sustainable growth rate and they kept their financial position intact and became a very strong player in their industry.

What were the differences between these companies? Both companies started out with similar turnovers ($78.8 million vs. $77.5 million). Four important differences are evident from analysing the companies:

  1. Company A has a much lower profit margin than Company B (1.4{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b} on an average yearly basis compared to 10.4{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b}). Company B’s profitability actually increased over time. Further analysis proved that Company A slashed prices and quite often did unprofitable business to gain market share. Their gross profit margins were on average below 20{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b} compared to more than 30{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b} for Company B. Company B often walked away from bad business and focused on selling their products on the basis of their value-added services.
  2. Company A financed their growth with extremely high debt compared to company B (11.3 times financial leverage on an average yearly basis compared to 2.2 times). A deeper analysis of Company A revealed that the initial 19.1 times financial leverage was not sustainable and the company then sold equity to finance growth and bring the debt ratio down. This proved not to be enough and finally the high debt levels came back to haunt them. In contrast Company B used less debt and they almost halved their financial leverage over the period. They are today extremely liquid and solvent.
  3. Company A paid a 26{da74ea48cec7d1c659e4125ffe517180d7bd6cbbe5631d32f11d21c45900f39b} dividend in year three. This made a critical difference at that stage. Further analysis showed that they could actually had a surplus (actual turnover minus targeted turnover according to sustainable growth rate) in year four of $3.3 million instead of a $7.8 million deficit. Company B invested all their profits back into the business and they reaped the profits later. A further analysis actually revealed that their expenditures (including salaries to director/shareholders) were much lower in relation to that of company A.
  4. In the final analysis Company A consistently grew faster than what they could afford. By year five they had a $348.7 million turnover – this gave a deficit of $47 million. They could not fund this additional deficit and it lead to their final demise. In comparison Company B grew to $178.9 million by year five – this is $5.4 million under their targeted turnover according to their 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, profit-taking before it was due and lack of focus. The company was finally liquidated.

On the other hand Company B chose a strategy of controllable and sustainable growth, strict financial discipline, limited risk and a focus on profitable business. Today the company is recognised as a market leader in their industry and their harvesting potential is excellent with many international players that already showed a keen interest in acquiring the business.