An owner of an IT
consulting firm spoke to me the other day about his business. His chief concern
was finding and growing revenue so he can grow his business. He indicated that
in some years he has generated more fee revenue than others, which caused him to
take-out or contribute funds to his business. Business has been good of late,
so he was struggling trying to figure out which projects to take on (e.g. large
projects with deferred fee collections and average realization rates or small
projects that would cash flow sooner at lower estimated realization rates). His
decision will impact how large his business will grow into the future. His
problem of determining how fast he can grow his business is similar to other
business owners and CEO’s I have advised and worked for. I listened to his
dilemma and responded to him by indicating that I understand his problem. I
congratulated him on his success and also commented that it is possible he ends
up in a liquidity crises or worse by growing revenue too fast given his
liquidity profile and financial model. With a look of disbelief, he asked me
how. My answer is as follows.
While most public and private businesses I have worked in,
modeled and followed, desire and are typically focused on growth, a smaller
number actually perform financial planning in a manner that, explicitly focuses
on the limits of sustainable growth (also
known as known as the sustainable growth rate (SGR). The definition of the
term is as follows.
SGR is the maximum
amount sales can increase without depleting financial resources which means
that there is a limit to revenue growth based on a given company financial
model. For an owner/operator consultant/CEO trying to grow a practice to
growing Fortune 500 businesses, it generally takes resources (i.e. more assets
that must be paid for) to increase sales.
The concept was developed by Professor Robert Higgins of
the University of Washington. Put another way, what he describes in general, is
the maximum rate of sales expansion an enterprise can undertake without issuing
debt or equity in a given unaltered capital structure. Since all company
balance sheets must be comprised of total assets that equal the sum of total
liabilities and equity, equity growth allows for growth in liabilities which
determines the rate in which assets can expand, which in turn determines the
growth rate in sales, as sales bear a relationship to the asset base in a given
enterprise. As Robert Higgins indicated, a company’s SGR is equivalent to its
growth rate in equity defined as PRAT. [i]
PRAT represents relationships between profit
margins, assets turnover, leverage and earnings retention as follows:
P = profit margin
A = asset turnover ratio, (P x A = return on assets
(ROA))
T = assets to equity ratio (i.e. leverage ratio)
R = retention rate (i.e. the portion of net income
retained in the business)
The first three terms (i.e. P, A and T) are sourced from
the DuPont ROE calculation method which is:
(Net income/sales) x (Sales/total assets) = ROA x
(Assets/equity) = ROE
ROE is then multiplied with the earnings retention rate
to arrive at the sustainable growth rate as follows:
ROE x (earnings retention rate) = sustainable growth rate
in revenue (SGR)
Higgins points out that SGR is the only revenue growth
rate that is consistent with stable values in the four ratios and that at least
one ratio must change if a company grows at any other rate than the SGR. Which
means that operating performance (measured by ROA) or its financial policy
(i.e. leverage or earnings retention) must change? Companies with growth rates
higher than SGR result in cash deficits. In response, companies can increase
profit margins or asset turnover thereby altering ROA or change financial
policies (i.e. leverage, equity issuance and earnings retention). Higgins
indicates that for long-term sustainable growth issues some combination of debt
increase, equity issuance, increased profits, divesting marginal activities or
merger with a cash cow would need to take place. Listed below is a summary of
the SGR:
Figure 1 - Summary of SGR (Gray boxes
are ROA related components, Green boxes are financial policy components)
Source: ‘How Much Growth Can
Borrows Sustain?”, George W Kester, 2002
In Figure 2 below we present the hypothetical financial
statements of a professional services firm that bills time at rates that absorb
payroll and other operating costs plus is sufficient to service debt and/or make
investments in assets.
Figure 2 – Hypothetical Balance Sheet
and P&L of Professional Services Firm
Source: “How Fast Can Your Company Afford to Grow,” Neil C.
Churchill & John W. Mullins, Harvard Business School Publishing, 2001 and
Gregg Carlson calculations/assumptions
Plugging numbers from the financial statements into the
SGR model yields the following results:
Net Income/sales = profit margin of 5%
Sales/Assets = asset turnover ratio of $2,000/$682 = 2.93
Assets/Equity = leverage ratio of $682/$432 = 1.57[ii]
Equals ROE and SGR due to 0%/100% debt to equity = 23.00%
The model indicates that the revenue SGR is 23%, which
means that growth rates above this number require better operational
performance (profit margin and/or asset turnover = ROA) or changes to the
capital structure (e.g. debt/equity issuance and/or increased earnings
retention) in order to avoid cash deficits, liquidity & working capital issues and/or
a conversation with your banker. An entrepreneur, owner or CEO would need look
at their realistic options in terms of operational performance,
financing/capital structure options, asset sales/divestitures or mergers. On
the other hand, entrepreneurs, CEO’s and owners who run enterprises at growth
rates that are less than their sustainable growth rates face issues of slow
growth, cash buildup and underutilized resources.
As an advisor to entrepreneurs, CEOs and business owners
I have also used other model-analytical tools to address the above issues such
as building explicit forecasts of company financial statements (P&L/Cash
Flow/Balance Sheet) and cash receipt/disbursement
models(daily/weekly/monthly/annual) to
calculate liquidity needs and cash flows.
In addition to SGR model described above and explicit
forecasts, I have found the operating cash cycle model to be a useful companion
to explicit forecasts as well as a logical framework as a management and
communication tool.
It is well known that businesses require cash and growing
businesses typically require more cash to fund working capital, operating
expenses and investments in facilities and equipment. A key concern of growing
businesses is to achieve a balance between generating and consuming cash. I
have found that focusing on the operating cash cycle to be a useful approach to
managing liquidity and determining the self financing revenue growth rate. The
discussion here is based on an analytical framework described by Neil C.
Churchill and John W. Mullins in a framework they developed for calculating the
self financeable revenue growth rate of a business.[iii]
Churchill and Mullins state that a growing business can
find itself out of business by outgrowing its cash resources. They address the
issue by developing a calculation known as the self financeable growth rate
(SFG). They develop a framework to determine what growth rate its current
operations can sustain and define three model factors as follows:
1)
Operating cash cycle – the amount of time
company money is tied up in inventory and other current assets before a company
is paid for the goods and services it produces;[iv]
2)
Amount of cash needed to finance each dollar of
sales, including working capital and operating expenses; and
3)
The amount of cash generated by each dollar of
sales.
Like the Higgins SGR model described here, the Churchill
and Mullins SFG framework goes beyond the calculation of sustainable revenue
growth rates as a tool that provides insight into how operational efficiency,
profit margins, product lines and customer segments can fuel revenue growth or
not.
The operating cash cycle is a calculation of how many
days cash is tied up in working capital before money is returned to the company
in the form of customer payments for goods or services sold. The shorter the
cycle the faster a company can redeploy its cash and growth from internal
resources. In other words, the fewer days in receivables and inventory, the
higher the turnover and the larger the number of days in payables, the better
the SFR.
In addition to working capital, the SGR framework
addresses how much cash is tied up in operating expenses by calculating how
much is invested in operating expenses per dollar of sales and how long the cash is tied up in the operating cash
cycle.
The SGR framework also considers how much cash per dollar
of sales flows to the bottom line and is available to fund the next operating
cycle after being consumed by cost of sales and operating expenses.
Based on the above, an operating cash cycle (OCC) growth
rate and the number of OCC’s can be calculated to arrive at an annual self
financeable sales growth rate (SFG). In Figure 2 – Hypothetical
Balance Sheet and P&L of a Professional Services Firm, I show the calculations described
here as follows:
1)
Cash
tied up per revenue/sales dollar in COS and operations adjusted for time (.40
+.08 = .48);
2)
Cash
generated per revenue/sales dollar (.05);
3)
Self
financeable growth rate (SFG) calculation (cash generated by sales divided by
cash tied up in operations) (.05 divided by .48 = 10.39% (SFG);
4)
Calculation
of number of OCC’s per year (365 divided by OCC 166 = 2.198;
5)
Annual
SFG is SFG (10.39%) x OCC’s per year (2.2 rounded) = 22.83%
The SFG is
the sustainable rate at which sales/revenue can grow. If the business grows
revenue at less than this rate, with all other variables held constant, the
business will produce more cash that it will need to fund its growth. On the
other hand, if its revenue growth rate is higher than its SFR, it will be
strapped for cash.
Levers
that the entrepreneur, business owner or CEO have for speeding up cash flow in
a way to allow for increased SFR growth rates
while avoiding the use of external financing fall within the three areas
and include; speeding cash flow through higher receivable and inventory turnover,
reducing operating expenses and/or increasing prices and margins. In this model
example I have not made adjustments for taxes, depreciation, asset replacement,
major investments in R&D and marketing as well as differing cash and operating
characteristics for different product lines within a business. In real life the
entrepreneur, business owner or CEO will need to do so.[v]
The model is capable of handling these inputs.
For an entrepreneur, business owner or CEO who must make liquidity
influencing decisions such as what customer or projects to take on, where to
price products/services vis-a-vis turnover/margins, what investments to make or
dissolve, how large to let assets grow and what target returns to aim for, the
models described here are helpful. In small businesses, I have seen the
concepts described here managed by intuition in lieu of a formal process. Size,
growth and complexity typically require more robust analytical and decision
making processes. Bigger businesses I have been involved with have traditionally
dealt with financial modeling of growth through an explicit forecasting process
of profitability, cash flow and assets/liabilities/equity. In many of these
cases, I used all or parts of these models to validate explicit forecasts. In
other cases, I have used modeling concepts discussed here in lieu of explicit
forecasts. The concepts modeled here have been used to advise and provide
insight to entrepreneurs, business owners and CEO’s in support of business
decision making processes.
I have
used a professional services firm as an example to illustrate the concepts in
the two models presented here. In the future, I will provide additional
examples of how these and other related models might be used to analyze the
growth rates and liquidity characteristics of businesses with varying financial
models such as “asset heavy” hotels and casinos or companies with significant
R&D investment in intellectual capital, among others.
For
additional resources see the footnotes below.[vi]
[i]
Analysis for Financial Management, Sixth Edition, Robert Higgins, 2001
[ii]
The model requires that beginning period equity be used for the
calculation. End of period equity of
$532 and net income of $100 = $432 of beginning period equity as the model
assumes no other changes in equity between the beginning and end of year.
[iii]
The discussion of the operating cash cycle framework was sourced from, “How
Fast Can Your Company Afford to Grow? Neil C. Churchill and John Mullins,
Harvard Business School Publishing, 2001. The financial statement data and
assumptions example used here are based on the article and then modified by
Gregg Carlson as a hypothetical example of a professional services firm.
[iv]
The components of the operating cash cycle include days of holding inventory,
receivables and other current assets as well as days in accounts payable and
other current liabilities to determine the length of time cash is tied up.
[v]
For additional information here, see page 8 – 9 of the article, “How Fast Can
Your Company Afford to Grow?, Neil C. Churchill and John Mullins, Harvard
Business School Publishing, 2001.
[vi] For
additional information on cash flows and liquidity issues see:
“Growth, Vitality, And Cash Flows: High-Frequency
Evidence from 1 Million Small Businesses,” JP Morgan Chase Institute, September
2016;
“How Much Growth Can Borrowers Sustain?, George Kester,
2002 and was originally published in June 1991 in The Journal of Commercial
Bank Lending;
“How Fast Should Your Company Grow?”, William E.
Furman, Jr., Harvard Business Review, January 1984
