Business Growth: A Case Study of Good and Bad Growth

Growth is fundamental to human nature. The same principle applies to business. A decline in growth often indicates trouble in a business and, if not reversible, can spell the demise of the company. Entrepreneurs are largely measured by growth and are usually actively seeking to achieve maximum growth and gain as much market share as possible. If this growth is not managed properly, it can backfire and can damage or even financially ruin a company.

For more than a decade, Ventex Corporation has 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, every detail simulates real-life scenarios closely enough to demonstrate actual learnings. The following points highlight key figures from 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) fell from 2.5% to 1.2%. Company B’s profit margin increased from 4.1% to 16.8% in the same period.
3. Asset turnover (turnover divided by total assets) for both companies remained reasonably stable over time. It averaged 2.3 for company A and 1.9 for company B.
4. Financial leverage (debt plus equity divided by equity) was 19.1 in the first year for company A and dropped to 12.3 in the fifth year. By comparison, company B had a financial leverage of 3.0 in the first year and it dropped to 1.6 in the fifth year.
5. Company A returned all profits to the business except for year three, when the retention rate was 74%. Company B had a retention rate of 100% throughout the period.
6. The sustainable growth figures showed that company A could grow to a maximum of $301.7 million in the fifth year (growing up to $348.7 million) and company B up to $184.3 million (growing up to $178.9 million).

Both companies were analyzed in detail. One of the most important insights came from Hewlett-Packard’s use of the basic sustainable growth rate (SGR) formula:

SGR = SWR*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 previous year’s figures. If there is a deficit (the actual turnover is greater than the target turnover based on the sustainable growth formula) for prolonged periods, it is very likely that a company will have financial problems and even go bankrupt. This is exactly what happens with company A. By 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 vs. $77.5 million). Four important differences are evident when analyzing the companies:

1. Company A has a much lower profit margin than Company B (1.4% on average per year compared to 10.4%). Company B’s profitability actually increased over time. Further analysis showed that Company A cut prices and quite often made unprofitable deals to gain market share. Their gross profit margins averaged below 20% compared to more than 30% for Company B. Company B often steered clear of bad deals and focused on selling their products based on their customer service. value added.
2. Company A financed its growth with extremely high debt compared to company B (11.3 times annual average financial leverage compared to 2.2 times). Further 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 levels of debt came back to haunt them. In contrast, Company B used less debt and nearly halved its financial leverage over the period. They are extremely liquid and solvent today.
3. Company A paid a 26% dividend in the third year. This made a critical difference at that stage. Further analysis showed that they could actually have a surplus (actual revenue minus projected revenue based on sustainable growth rate) in year four of $3.3 million instead of a deficit of $7.8 million. Company B invested all of its profits in the business and then reaped them. Further analysis revealed that their expenses (including directors/shareholders’ salaries) were much lower relative to Company A.
4. In the final analysis, Company A consistently grew faster than it could afford. By the fifth year, they had a turnover of $348.7 million, giving a deficit of $47 million. They were unable to finance this additional deficit and it led to their ultimate demise. By comparison, Company B grew to $178.9 million in the fifth year; this is $5.4 million below its target turnover based on 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 turned out to be one of uncontrollable growth, lack of financial discipline, unnecessary risks, taking profits early, and lack of focus. The company was eventually liquidated.

For its part, Company B opted for a strategy of controllable and sustainable growth, 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 harvest potential is excellent with many international players already showing great interest in acquiring the business.