Tag Archives | sustainable growth rate

Pitfalls to Avoid When Growing Your Business

A strong economy drives business growth. I think most of us can agree on that. Growth is usually good…

But if it is not controlled growth, it simply will not be sustainable.

In this blog, I outline several pitfalls to avoid when growing your business (especially in a high growth scenario). It’s all about managing the growth properly.

We have two current clients that are experiencing high growth, and they can barely make payroll.

With a pipeline of huge sales, how can this be possible…?

Their lack of planning on systems and procedures has also caused the management to not sleep well at night.

SCFO Lab Members: The reason most income statement projections fail is because of a lack of ability to accurately project sales! Start the Sales Genie EP now.

What Happens in a High Growth Scenario?

So, what happens in a high growth scenario? It should be all good news… The problem is that many times the decision maker(s) of a high growth company have never experienced high growth. Sometimes, these can be startups or a business that developed a new product.

If you have not experienced it, then it really is hard to imagine all the things that can take place.

Example of a High Growth Scenario

Let’s look at an example of a high growth scenario in a made-up company…

You are a manufacturer of widgets and you own a manufacturing facility. You have 50 employees before the company is about to explode in growth.

Your VP of Business Development or VP of Sales brings you new contracts that will significantly change the size of your company.  These contracts will double, triple, or even quadruple your business in the next 18-24 months.

So no worry about generating sales….

But there are several questions that need to be asked and pitfalls to avoid in this company.

Pitfalls to Avoid When Growing Your Business

Inventory: How are you going to fill all those orders?

You need to purchase a lot of inventory of raw material. In addition, your purchasing transactions just tripled in dollars and quantity. Finally, you have enough machines to manufacture items for the next 12 months… But next year, you will need to acquire more machines to keep up with demand.

Labor: What about labor?

The purchasing person is working already 50 hour weeks, and you know you will need to hire another purchasing person. Your plant labor needs to increase to compensate with the increased workload.

Right now, your 3 person accounting team includes 2 bookkeepers and a controller. You realize you need a cost accountant.

Systems, Process and Procedures

You have used a basic accounting system for 10 years, but you realize that you have outgrown the accounting system. It is not the right system because it does not handle cost accounting or standard costs. You want to integrate purchasing and inventory modules.

For years, you kept inventory and work-in-process on spreadsheets. Now, the dozens of spreadsheets are not reconciling. It’s time to automate inventory.

The once per year physical count of inventory is no longer enough. You need to have cycle counts and maybe at least a full physical count quarterly.

For years, you have operated informally, but you now you realize you need to have written policies and procedures.

Accounting

You have run your business on a hybrid cash/accrual system, never really got to full accrual accounting, and never really worried about GAAP financial statements. Maybe you should…

You never considered having your financial statements audited; however, with all this growth, you might sell one day. Having your financial statements audited would add value to your business.

Your company is growing so much, you need more than financial statements that tell you what happened in the past. Now, you need projections, budgets, and dashboards.

It’s time for a strategic financial partner. It’s time for a CFO.

Click here to access our Goldilocks Sales Method, and learn how to build your sales pipeline and project accurately.

Human Resources

Your admin person that did a great job all these years is now dealing with 3 or 4 times as many employees. It’s time to hire someone that has a good understanding of labor laws.

Payroll was done in house. Now with so many hourly people and manual time sheets, it’s time to upgrade and integrate payroll to the accounting system or have it outsourced.

Consider automated time keeping and get away from the multiple spreadsheets.

Legal and Tax

Your new sales take you out of State. Now, you are selling in 5 different States.

Have you created nexus in these other States? They have State taxes… Oops!

You had to hire a few people on the ground in the other States; your labor laws just got really complicated.

Sales and Use tax… Are you paying the correct taxes, not paying them, or over paying them?

You developed a new process or Intellectual Property (“I.P.”). Did you register this? Did your attorney suggest maybe creating a new legal entity that has the I.P.?

By creating the new legal entity or new legal entities, did you realize you just created a lot of complex accounting work by having all those legal entities?

Note: We recently had a client that created 19 legal entities because their attorney wanted to “protect” them from everything. Now, they had to consolidate all those entities with hundreds of intercompany transactions.

What is your Exit Strategy?

You will be quadrupling the size of your business in the next 2-3 years. You thought to yourself one day… I might want to sell this business.

What does it take to sell your larger company?

It takes time to set a strategy for an exit. It takes time to “professionalize” management and your back office.

Do you have a succession plan so that the business does not look like a one man show?

Do you have a 3-year budget with projections?

SCFO Lab Members: If you want to build your exit strategy and/or access your readiness for market, check out the Exit Strategy EP

How to Have Sustainable High Growth

I have hit on some of the basic topics that come up in a high growth scenario. There are many more things to consider.

The first thing that comes to mind is how are you going to pay for all this?

Do you have sufficient working capital?

Sometimes, you can manage working capital and have sustainable growth.

Many times, you need some sort of financing because of the timing differences in working capital. You cannot afford to sustain this high growth with out the financing.

Cash and working capital are key to the sustainable growth.

But just as important is having the right people. Not just having the right people on the bus… But having them in the right seat on the bus is critical. Not everyone is meant to sit in the same seat in a larger company. This applies to the management team as well as employees.

I have actually seen situations in high growth companies where the person that really needed to be fired was the owner or CEO.  Because the CEO of a $5 million dollar company is not necessarily the same CEO of a $50 million dollar company.

Don’t get me wrong… The ownership does not have to change. You can still own the business. But that does not mean you need to be an employee running the business.

Summary

In order to have sustainable high growth that will allow you to sleep well at night consider the above items but you must have the following…

  • Enough working capital
  • The right people in the right seats on the bus
  • More and difference systems, process, and procedures
  • A strategic plan that will allow you to have a sustainable bigger company

Projections are a helpful way to grow sustainably and avoid an uncontrollable high growth scenario. Download our free Goldilocks Sales Method to start building your pipeline and projecting accurately.

Pitfalls to Avoid When Growing Your Business

Pitfalls to Avoid When Growing Your Business

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Impact of FIT on Sustainable Growth Rate

The Institute of Fiscal Studies authored a study on tax systems in the UK called “Tax by Design: Mirrlees Review.” They concluded that “in the long-run, the tax system should be judged in part on its impact on the sustainable growth rate of the economy… viewing efficiency in a dynamic as well as static sense.” As we enter into tax season, you as the financial leader of your company should understand the impact of FIT on sustainable growth rate in your company.

What is Sustainable Growth Rate?

Sustainable Growth Rate (SGR) is the maximum amount of growth that an organization can sustain without increasing their financial leverage. It commonly suggests the percentage (%) growth in revenue that an organization can sustain with its current profit margin, earnings retention rate, leverage, and asset turnover.

Sustainable Growth Rate (SGR) = (1-d) x ROE

Dividend Payout Ratio (d) =  dividends / earnings

Return on Equity (ROE) = net income / shareholders’ equity

Even though there are numerous methods to increase your sustainable growth rate (such as increase the profit margin, asset turnover ratio, assets to equity ratio, or retention rate), the federal income tax can blindside you if you don’t prepare for it. FIT is unavoidable.

There are several economic theories concerning FIT, including the Laffer Curve and Reaganomics, that can be utilized to understand the impact of FIT on your SGR.

Laffer Curveimpact on sustainable growth rate

The Laffer Curve, created by Arthur Laffer, demonstrates the relationship between governmental tax revenue and tax rates. It important to understand this curve because at any given point on the curve, the amount of financial leverage you can supply to spur growth will differ.

If the tax rate is at Point A, then the government isn’t necessarily pleased by leaving your company with more dropping to the bottom line. This level of tax rates allows for your company to be more productive. Not only will you be able to breathe easier knowing you don’t owe the government so much, but your employees will be incentivized to work harder. They now know that their hard-earned money will land in their pockets. But having low tax rates isn’t always ideal. This is because your employees don’t have to necessarily work more to attain the “same” amount of “success” as they would at the Equilibrium Point.

If the federal income tax rate is at Point B, then both your company and your employees will question why should work be done. Since the government will be taking away 80-95% of revenue or income, the motivation to work will decrease significantly. At the point, your sustainable growth rate will be affected dramatically because the amount of financial leverage you have to spur growth is minimal. This point is typically seen in dictatorial economies.

Like in all things, there is an Equilibrium Point. This point allows for the government to make money as well as your company. Productivity remains high, allowing you more flexibility to provide growth in the company.

Although you cannot control the tax rate that the government has set, know how it impacts your company. One way to do this is by understanding the history of income tax rates.

Reaganomics

impact on sustainable growth rate

President Ronald Reagan called for widespread tax cuts during his presidential election in 1980. Within this economic plan, we saw four major factors:

  • deregulation of domestic markets
  • increased military spending
  • widespread tax cuts
  • decreased personal spending

The hope in implementing this plan was to reduce company’s expenses (primarily from tax expenses) to improve the economy as a whole. But as we saw with the Laffer Curve, there is a point when federal income taxes could be too low to improve the sustainable growth rate of a company.

Impact of FIT on Sustainable Growth Rate

In any company, cash is king. One of the major cash expenses that every company has is federal income taxes. Any tax strategy used to drive financial performance should not be considered as the end-all-be-all. The FIT reduces the amount of cash or financial leverage you have to increase your sustainable growth rate.

However, there are mechanisms or key performance indicators (KPIs) that you can utilize to focus on increasing your internal financial leverage. FIT is something that you cannot avoid. It will affect your sustainable growth rate. But by using a few indicators to measure profitability, etc, you’ll be better able to increase your SGR.

(NOTE: Want to start measuring your company’s KPIs today? Check out our KPI Discovery Cheatsheet!)

When calculating your sustainable growth rate, it’s important to recognize that any positive rate can allow for growth. It’s imperative to calculate FIT when you’re expecting or desiring growth.

Sustainable Growth Rate (SGR) = (1-d) x ROE

ROE (net income / shareholders’ equity) should have your FIT factored in. It’s easy to forget this important step until you find your wanting to utilize your internal financial leverage and you lost 35% of profit, severely reducing the financial leverage that you thought you had. Know the impact that the federal income tax has on your sustainable growth rate.

If you want to track your sustainable growth rate, then download your KPI Discovery Cheatsheet today.

impact of FIT on sustainable growth rate

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impact of FIT on sustainable growth rate

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Sustainable Growth Rate

See Also:
Compound Annual Growth Rate (CAGR)
Internal Rate of Return Example
Impact of FIT on Sustainable Growth Rate

Sustainable Growth Rate Definition  

The sustainable growth rate (SGR) is a company’s maximum growth rate in sales using internal financial resources, while not having to increase debt or issue new equity.

Sustainable Growth Rate Explained

Companies who plan ahead and maintain sustainable growth rates will ultimately circumvent unprofitable growth. Thus by managing the growth rate, companies can avoid straining financial resources and overextending their financial leverage. Rapid growth and increased sales are dependent on financial resources. So, in order to improve sales in sustainable growth, a firm will need new assets, which can be financed through an increase in owners’ equity (retained earnings).

If a company plans to increase the SGR without issuing new equity or borrowing additional financial resources, then it should increase the profit margin, asset turnover ratio, assets to equity ratio, or retention rate. By using the return on equity and dividend payout ratio, the SGR then enables firms to forecast future equity and develop optimal growth rates.


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Calculate the sustainable growth rate using the following two equations.

Sustainable Growth Rate Formula 1

When you use the Return on Equity and dividend-payout ratio, you should use the following SGR formula:

SGR = (1-d) x ROE

d is the Dividend Payout Ratio (dividends divided by earnings). ROE is the Return on Equity (net income divided by shareholders’ equity).

Sustainable Growth Rate Formula 2

The second equation to calculate the sustainable growth rate is to multiply the four variables for profit margin, asset turnover ratio, assets to equity ratio, and retention rate:

SGR = PRAT

P is the Profit Margin (net profit divided by revenue). Whereas, R is the Retention Rate (1 minus the dividend payout ratio). And A is the Asset Turnover Ratio (sales revenue divided by total assets).  Finally, T is the Assets-to-Equity Ratio (total assets divided by shareholders’ equity).

Sustainable Growth Rate Example

What is the sustainable growth rate for a company with Shareholder’s Equity of $400 and net income of $100? Reinvest $40 of the net income as dividends.

ROE = net income divided by shareholders’ equity = 100/400 = 25% or .25

Dividend-payout-ratio = dividends divided by net income = 40/100 = 40% or .40

SGR = (1-d) x ROE = (1-.4) x .25 = 15% or .15

From this example, the SGR works out to be 15%. First, calculate SGR by multiplying one minus the dividend-payout-ratio by the return on equity. A SGR of 15% indicates that the company can increase future earnings and sales up to 15% annually without having to borrow more funds or issue new equity. Learn other ways to increase the value (and cash flow) of your company by downloading the free 25 Ways to Improve Cash Flow whitepaper.

Sustainable Growth Rate

Strategic CFO Lab Member Extra

Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

Sustainable Growth Rate

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