Learning objectives

Recognize how growth can put a firm’s balance sheet out of order.
Identify the factors that would determine how much external financing is needed.

Introduction

This section develops a simple forecasting model that permits the analyst to determine how fast a growth pattern a company can sustain. This approach can be a valuable planning tool.

Definitions

SA	Spontaneous assets – These are assets that generally need to increase as sales increase. They include most of the current assets, but not short term investments.
ΔFA	Change in net fixed assets – This includes new, fixed asset acquisitions, less depreciation expenses.
PO	Payout ratio – This is the proportion of earnings paid out as a dividend. The retention ratio is (1 – PO).
PM	Profit margin – This is often called the net profit margin and is net income divided by net sales revenue.
EFN	External financing needed – This is the amount of additional long-term financing needed from external debt and equity sources.

Derivation of the sustainable growth model

The model comes from the equation used in the sales method forecasting model.

An expression for new debt and new assets can be set up that equals our target debt to asset ratio for the increased business.

By substituting the value of EFN from (1) into (2) and solving for ΔS, we can obtain the solution.

By plugging in the values that we know, we can determine the maximum ΔS with our desired D/A ratio as a constraint.

Most companies place some limit on the amount of debt they are willing to assume. In addition, raising new equity capital is difficult and may be virtually impossible for most small businesses. Thus, as long as a target debt to asset ratio is not to be exceeded, growth is limited.

In order to determine the maximum growth potential for a given time period, one must begin with a determination of the amount of equity that can be raised internally. This amount depends upon the new sales level (which depends on the amount of internally generated equity). This joint dependence between the new sales level and new equity can be solved only with simultaneous equations:

The model takes the EFN equation.
Assumes that the company wants to limit its debt to asset ratio.
Finds the maximum amount of sales growth:
- Sales growth requires assets.
- Assets require debt or equity or both.
- Limited equity and desire to limit the debt to assets ratio limits the amount of new assets.
- The limit on assets in turn limits sales.

The Alabama door company

20X7 balance sheet
Cash	$5,000	Accounts payable	$3,000
Marketable securities	5,000	Taxes payable	12,000
Accounts receivable	10,000	Accruals	3,500
Inventory	35,000
		Total	18,500
Total	55,000
		Notes payable (8%)	15,000
Building	100,000	Bonds payable (12%)	30,000
Equipment	15,000	Common stock	48,000
		Retained earnings	58,500
Total assets	$170,000	Total debt and equity	$170,000

Selected income statement figures 20X7
Sales	$245,000
Net income	19,008
Dividends	15,000

Assumptions

Assume that $5,000 of new fixed assets are required.
The Alabama Door Company wants to maintain its 37.4 percent debt to asset ratio.

Class exercise

Compute the Alabama Door Company’s maximum growth rate for 20X8 if no new externally generated equity is available.
Recompute the Alabama Door Company’s maximum growth rate for 20X8, assuming that $20,000 of new fixed assets are required.

Calculation of Alabama door growth rate

The Alabama Door Company can have a sales increase of $7,891 with the $5,000 increase in fixed assets and the debt to asset ratio remaining at 37.4 percent. Growth beyond $7,891 will require new equity or a relaxation of the debt to asset constraint.
If fixed assets must increase by $20,000, ΔS becomes negative, implying that assets cannot increase by the specified amount without new equity or a relaxation of the debt to asset constraint.

Improving sustainable growth

What would happen to ΔS if the profit margin increased to, say, 10 percent?
What would happen to ΔS if the payout ratio dropped to 50 percent as well as the change in (1) above?

Knowledge check

If a company can increase its profit margin, its sustainable growth will
1. Increase.
2. Decrease.
3. Not be able to be determined.
4. Not change.

Sustainable growth: Available external equity

In some instances external equity is available to finance growth. Existing stockholders or new stockholders (partners) may have a fixed sum of equity to invest in the company.

If we define the amount of externally generated equity to be EE, then the growth formula becomes as follows:

If we return to the example of the Alabama Door Company, part 1, the growth in sales can be computed for the case in which $10,000 of external equity is available.

The change in sales for this example is considerably larger than that which could be afforded when no external equity was available. The increased equity allows for more debt financing while still keeping the debt to asset ratio at 37.4 percent. The increased debt and equity permits assets to grow sufficiently to support the larger sales volume.

Knowledge check

When owners add equity to a company, its sustainable growth will
1. Increase.
2. Decrease.
3. Not be able to be determined.
4. Not change.