Financial Analysis of Growth Revised

Financial Analysis of Growth
Prof. Santosh Sangem

XLRI, Finance Area

 Growth as an important objective of managers

 Growth desirable for owners
 Higher Value & Capital Gains
 Growth of What?
 Sales
 Operating Profits
 Total Assets
 Net Profits
 Growth Life-Cycle
 Start-up
 Rapid Growth
 Maturity
 Decline
 Growth as requiring additional resources

 Growth trade-offs
 Growth & Financial Resource Depletion
 Growth & Profitability
 Growth & Efficiency
 And so on..
 Focus on financial factors only
 Sustainable Growth Rate Concept
 Maximum rate of sales growth without straining financial
resources
 Maximum rate of sales growth without straining profitability
and efficiency

 The Sustainable Growth Rate Model

 3 variants
 Based on target capital structure
 Based on drivers of ROE
 Based on Operating Cycle
 Common underlying theme of sales growth maximization
 Equilibrium models
 Short-Term & Medium-Term
 Long-Term growth rate limited by GDP growth rate
(domestic/world)
 Conversely can be used to determine growth rates for a desired
configuration of financial structure, profitability & efficiency

The Original SGR Model- Higgins (1977, 1981)
 The Classic Sustainable Growth Rate Model

 The Question: Are the targeted growth policies and financial
policies of the firm in sync with each other
 An equilibrium growth rate model
 Assumptions
 Constant Net Profit Ratio
 Constant/ Target Dividend Payout Ratio
 Target Debt-Equity Ratio
 The basic logic:
 (Required Increase in Assets)t+1 = Asset Turnover Ratio * ∆Sales
 (Incremental funds)t+1 = Retained Profits + Incremental Borrowings

 SGR (∆S/S) =
(Net Profit Ratio * Retention Ratio)* (1+ Debt-Equity Ratio)
(1/Asset Turnover Ratio)- {(Net Profit Ratio * Retention Ratio)*
(1+ Debt-Equity Ratio)}
 SGR (∆S/S) =
(Net Profit Ratio * Retention Ratio)* (Total Leverage Ratio)
Asset Intensity Ratio- {(Net Profit Ratio * Retention Ratio* Total
Leverage Ratio}

 SGR gives
 Equilibrium rate of Sales Growth
 Equilibrium rate of Profit Growth
 Equilibrium rate of Asset Growth
 Equilibrium rate of Net Worth Growth
 Model Insights
 Higher growth must be accompanied by either higher retention,
higher borrowings, higher profitability or at by higher
efficiency

Dividend Discount Model & the SGR Formula
 Gordon’s Dividend Discount Model

P0 = D1/ (ke – g)
 Constant growth rate of dividends
 An equilibrium valuation model
 Growth Rate (g) = Retention Ratio (b) * Return on Equity (ROE)
 ROE = Net Profit Ratio * Asset Turnover Ratio * Total Leverage
Ratio
 SGR = Net Profit Margin (P)* Asset Turnover Ratio(A)* Retention
Rate (R)* Total Leverage Ratio (T)
 An easy acronym- PART
 Allows linking with the various approaches to ROE decomposition
 Difference with Higgins’ SGR formulation
 Less Restrictive Assumptions
SGR Models
 Problems with SGR Models in General

 Negative Profitability
 Extreme Leverage
 Low Asset Base

A Graphical View
 Suppose, equilibrium values of A, R, & T are 5, 0.30, & 2.5
Cash Deficits
Growth Rate of Sales
Cash Surplus
Net Profit Ratio

Operating Cycle & SGR
 Key Drivers of Sales Growth

 Cash Profitability
 Duration of Operating Cycle
 Investment of funds in Operating Cycle Assets (Net Working
Capital)
 Sales growth that can be sustained through internal fund generation
only
 Does not consider financial leverage
 Provides an all-equity finance equilibrium growth rate

The Operating Cycle & SGR
 Duration of Time for which funds blocked in the form of Net

Working Capital
Inventory Holding WIP Holding Debtors Collection

Period Period Period
+ +
Gross Operating Cycle
-
Creditors Payment Period
Net Operating Cycle

Operating Cycle & SGR
 Cash Profitability Ratio = Cash From Operations / Net Sales

 2 components of Investment in Operating Cycle Components
 Annual Manufacturing Expenses * Net Operating Cycle/365
 Funds blocked for payment of other operating expenses during
operating cycle – (Annual Operating Expenses * Gross
Operating Cycle/365)
 Number of Operating Cycles in a Year = 365/ Gross Operating
Cycle
 Cash Flow Return on Operating Cycle (CFROC)
 Cash from operations/ Total Operating Cycle Investment
 SGR = CFROC* Number of Operating Cycles in a year

Some insights of the Operating Cycle based
approach
 Applicable for both manufacturing & service sector firms
 Higher Growth Rate may be attained by
 Reducing gross operating cycle duration
 Reducing costs – Higher Cash Profits & Reduced investment in
operating cycle
 Increasing Prices
 Assumption of no asset replacement expenditure
 Substitute “Free Cash Flow” for “Cash from Operations”

Which approach to use for SGR?
 Different implications/approaches to increasing growth rates

 Operating cycle based approach more conservative
 Implicit that leverage does not matter
 More appropriate for high risk aversion cases
 Evaluation of impact of controllable drivers
 Higgins’ SGR & its variants less restrictive
 Allow external financing
 Higgins’ SGR to be preferred with operating cycle based approach
as a cross-check

Implied Growth
 Important to evaluate market expectations of growth

 Reasonability of Expectations
 Forward Looking Statements
 Implied Growth Rate from two sources
 Valuation Models & Market Price Multiples
 Prices of Bonds
 Bond Price based implied growth not much useful in Indian Context
 Implied Growth Logic
 If ROE is greater than cost of equity, higher growth priced in by market
 Implied Growth is a Perpetual Growth Number
 Is the Implied Growth Rate Justified??
 Compare with Long-Term Growth of National GDP for a Domestic
Company
 Compare with Global Long-Term GDP Growth for Multinationals

Implied Growth
 Using P/E Ratio for Implied Growth Rate

 Implied Growth Rate = Ke - (1/PE)
 Using P/B Ratio for Implied Growth Rate
 Implied Growth Rate = Ke - ((ROE-Ke)/(PB-1))
 Preferably calculate both
 Perpetual Growth Rate in Nominal Terms
 Implied Growth Rate using P/B ratio more reliable
 Lower Volatility
 Implied Real Growth Rate (Hassett, 2010)
 Based on Stephen Hassett’s RPF Model of Valuation
 Implied Real Growth Rate = (Ke- Rf)-Real Interest Rate- (1/P/E)
 Problems
 Sensitivity to Cost of Equity Calculations
 Reliability of Cost of Equity & Market Efficiency

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Financial Analysis of Growth

Prof. Santosh Sangem