Shares digital

It is all too easy for growth to go to a company’s head, but in terms of investment it is vital that a sustainable rate is maintained. Peter Webb weighs up the precarious balance

Growth to a company is like oxygen to a human. Just about the right amount and you are OK. If you get starved of it you will die, but too much can also cause an equally dangerous imbalance. What is the right level of growth for a company, how can that be managed and can you pinpoint any danger signs?

Understanding what rate of growth a company can sustain is an important part of investing. A growth rate above this sustainable rate means the company will need to raise new money from somewhere. If it finances this money through the use of debt, the risk of bankruptcy rises; if it raises it through issuing new shares your stake in the company is diluted. It is always better if growth can be funded from retained capital. Growth below this sustainable rate may mean it makes more sense to return capital to shareholders. Maintaining balance is important; this will allow a company to prosper for the ultimate benefit of shareholders.

Balancing the books

One clear indicator of whether things are moving in the right direction is the size of growth on the balance sheet. This can occur for a number of reasons but a rise in total capital in use against lower respective growth in earnings should attract your attention. Ideally, in a good cash cycle, excess cash should be generated and used to repay long-term debt. If the use of funds is out of balance or lots of capital is being used to fund growth, excess cash is not generated, debt is not repaid and new funding is needed to keep the company moving.

Funding growth

In this particular example we are looking at three factors; current assets divided by current sales, retained earnings divided by sales, and growth in sales. You have to make some assumptions in every form of analysis that you do. For this example the relationship of current assets to sales is 0.40, for each £1 of sales we need £0.40 in assets. We are assuming that the growth in asset use is going to be linear to the growth in sales. In others words we assume that if we spend more money on stock and other costs, sales will rise by a proportionate amount. We also make similar assumptions for the amount of retained earnings per £1 in sales. If we use these values and assumptions we can estimate a sensible rate of self-funding growth for the company. To do this we simply take current retained earnings and divide it by growth, multiplied by the amount of current assets needed to generate the sales that generated those earnings. By doing this we can see if the company is under funding its future growth.

In this example of a FTSE 250 company, you can see that to reach equilibrium, growth needs to be 6.85%. At this level it can fully fund future growth from retained earnings. In fact, sales grew 7% last year and, hey presto, debt increased in response. In fact, with just a 3% uplift in this year’s earnings, 7% growth would be self funding. If we increase the growth rate to 10%, which would surely see a re-rating on this share, only 68% of the funding requirement can be achieved through retained capital. Trying to push growth harder has meant the company would need to raise further funding.

Smart management

It's a delicate balancing act, if the company wants to grow it needs more funds. Those funds would ideally come from retained earnings, but if these do not deliver the capital required more funds may be needed. This will be achieved by either taking on more debt or issuing more shares and diluting your investment in the company. Smart management, however, will be looking at such an equation and can modify the operational aspects of the business to improve the ability to retain cash or reduce the potential funding burden. They have several clear options: -

• Reduce growth to a sustainable level: By reducing growth you reduce the dependence on raising new funds and taking on board more risk.

• Increase the amount of retained capital: Cut the dividend, reduce costs and make the company more profitable allowing it to retain more capital.

• Achieve more efficiency: If you reduce the amount of assets it takes to make a sale then that will also deliver more growth without raising additional capital. Getting extended credit terms from suppliers, for example, is an easy way of achieving this.

Companies can of course do all three and this is what you should expect a well-run company to aim for. Ideally the board of a company should adopt the optimum funding and growth rate to ensure shareholders don't become beholden to too much risk or too little growth. Therefore, if you see a company with ambitious growth targets it's always worth checking to see if it's affordable.