When reading the various industry periodicals and newsletters, there is often mention of top firms and their secrets for success. There are various aspects of success, such as employee morale, diversity of technical expertise, and revenue, which are used as yardsticks against which many of us compare our own companies. However, as we are often advised, there is no one variable that, even if properly managed, will guarantee future success. Every firm is different, and each must be managed based on the characteristics of performance that are typically found on, or calculated from, the company’s financial statements.
One of the useful tools available to management is the concept of the Sustainable Growth Rate (Reference: Analysis for Financial Management, 7th edition, by Robert C. Higgins; published by McGraw Hill, 2004). While managers and directors should be expected to have a grasp of this concept, even technical employees should educate themselves about the financial health of their employer. Not only is it fairly easily applied, but the factors in the growth equation are also relatively straightforward, easily understood, and products of standard accounting practice. More difficult, however, is the interpretation of the difference between a firm’s actual growth rate and the calculated sustainable rate. The details are beyond the scope of this brief article, but the following provides some guidance.
The sustainable growth rate indicates the rate at which revenue may increase without altering the company’s operations and fiscal policies. If the actual growth rate is higher, it indicates that the company may be using too much cash and may end up needing to borrow heavily in the future. Alternatively, a lower growth rate indicates that the firm may have excess cash that is not being used effectively to convert assets and labor into profitable products and services. The solutions to either problem are complex and depend on management attitudes, industry trends, financial markets, and competitors, just to name a few. The complete decision on any course of action requires input from operational managers, financial officers, vice presidents, and board members.
The sustainable growth rate calculation itself is simple arithmetic. The sustainable growth rate, g, is defined as:
g = (P) (R) (A) (T)
P = Profit Margin = Net Income/Sales;
R = Retention Rate = Percentage of earnings not distributed to shareholders;
A = Asset Turnover Rate = Sales/Assets; and
T = Asset-to-Equity Ratio = Assets/Shareholders’ Equity.
Each of these terms can be easily found in the financial statements and observed over time to identify trends. Additionally, each term is a valuable measure of particular aspects of the business that can be studied individually. Most noticeable is that there are two terms that cancel out: Sales and Assets. While this could be done to reduce to a simpler equation, their presence is important. If management desires an annual growth in revenue of 7 percent, but the sustainable growth rate is only 5 percent, it is not enough to simply adjust sales. Some broader effort must be made to affect the net income or asset turnover, for instance. Put another way, the company’s operations (sales) are directly tied to its financial policies; it is not possible to change one aspect while leaving everything else constant. The take-home message is that management has many tools at its disposal to measure and adjust performance. It is shortsighted to focus on simple sales figures and projections as a benchmark, or to think that astronomical growth every year is a good thing. What works for a small start-up is not the way of a more mature company. Balance is key.
An even more important message, however, is that management should be prepared to discuss some of these concepts with employees, whose efforts have a direct effect on the sales, net income, and dividends of the firm. If part of becoming a professional engineer is participating in project management and business administration, then it is necessary to have an understanding of such basic measures of financial performance. Do not be afraid to inquire, even if certain information may turn out to be sensitive or confidential. One does not need to see all the books to be able to observe many of the important aspects of their employer’s financial health.