Clues to Reports from Winter FinListics Newsletter

Showing your Clients How to Sustain Growth

by Becca Sundal, Director of Client Services at FinListics Solutions

Difficult times call for difficult measures. And many companies in almost every industry are being forced to make tough decisions, cut costs and reign in expansion plans.  Yet, even with such measures in place, growth and profitability remain stagnant or worse. While questions about the economy persist, there appears to be light at the end of the tunnel.  That said, when recovery does occur, how will these companies fund the growth needed to capitalize on some of these cost reductions?

A key requirement: companies must have the capacity to generate and handle growth. Working capital, new facilities and refurbishment of existing facilities all cost money. How will these be funded? With the current credit environment, many organizations are looking to finance growth from internally generated sources, such as funds from operations, while maintaining the same amount of debt funding as a portion of assets. How much they can grow using only these sources is measured by what we call the Sustainable Growth Rate. This is calculated as:

Retention Ratio X Return on Equity (ROE)

• Retention Ratio – the percentage of earnings invested back into the business vs. paying out in dividends. On financial websites or in company annual reports, the payout ratio (also called the dividend payout ratio) is often reported. This is the inverse of the retention ratio. (To calculate the retention ratio using the payout ratio, use [1-payout ratio])  Multiplied by:

 Return on Equity (ROE) – the book return to shareholders. You can find this on individual company pages on financial market websites, usually listed under Key Statistics.

For example, Retailers R Us has a 12% ROE and a 50% retention ratio, which results in a 6% sustainable growth rate. Any growth above 6% must be funded by one or more of three sources:

• Draw down cash balances. Many companies are trying to rebuild these balances after depleting them during the recession.
• Increase the debt to assets ratio. Organizations want to reduce the percentage of assets funded by debt to increase financial flexibility and because of higher borrowing costs. 
• Issue stock. Most companies don’t want to issue stock since prices remain well below historical highs.

To avoid using these three sources, many companies are exploring operational initiatives to strengthen their sustainable growth rate by increasing ROE. Without going into all the details, two important drivers of ROE are:

• Profitability – profits expressed as a percentage of revenue
• Asset Utilization – dollars of revenue generated per dollar invested in total assets

 Key general initiatives to improve ROE:

• Increasing profitability by better managing product mix, pricing and operating expenses.
• Boosting asset utilization through more effective management of working capital (accounts receivable, inventory and accounts payable) and fixed assets like facilities, premises and IT infrastructure.

What happens if your solutions help enhance profitability and asset utilization, while increasing the ROE of Retailers R Us to 15% from 12%, holding everything else the same? The new sustainable growth rate becomes 7.5% (15% ROE x 50% retention ratio), which represents an increase of 1.5% or 150 basis points. This means that for each $100 million in revenue, the company could fund an additional $1.5 million ($100 million x 1.5%) in top-line growth.

From a tactical perspective, the jump in cash flow from the improved ROE is of great interest to your client. However, it’s also important that you highlight its more strategic impact on sustainable growth – a major consideration for funding top-line growth opportunities.