The two big business strategy decisions you must make about growth are:
1. How much leverage you’re comfortable with
2. How much cash to distribute to owners
Business owners pursue growth out of entrepreneurial instinct. Growth can mean opportunity and profits. However, your financial risk increases when you chase too little or too much growth. What are the keys to growth? The answers lie hidden in the sustainable growth rate formula.
The sustainable growth rate formula tells you the maximum amount your sales can grow without needing more cash from debt or equity. It’s a simple way to quickly estimate your growth potential based on some cash flow assumptions.
The three big numbers in the formula are your:
- Return on Assets (ROA) – A measure of profitability
- Leverage – A measure of how much debt you have
- Earnings retention rate - The amount of earnings reinvested in the company instead of being distributed to owners
Company owners rarely disagree that a higher ROA is better. The two big business strategy decisions you must make about growth are:
- How much leverage you’re comfortable with
- How much cash to distribute to owners
An owner with a high tolerance for risk will want more leverage than an owner who places a high value on the safety and sustainability of the company. These two owners will have to negotiate a compromise.
An owner who needs large cash distributions to fund their lifestyle will clash with an owner who wants to focus the company on growth.
Of course, you always have another option to grow beyond the sustainable growth rate: get more cash from outside equity investors. But that involves selling off part of the company. It means you get a smaller share of future earnings and at least a partial loss of control. For some owners, that’s not a price their willing to pay. For them, they are limited to the sustainable growth rate.
I wish you smart, strategic, and sustainable growth. I wish you well.
- Rob Stephens
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