PART 5: SPECIAL TOPICS
practical appeal. Our goal is to demonstrate a simple model that highlights the trade-offs that companies
must weigh when they choose to grow. These trade-offs depend on several factors: how rapidly the
company plans to grow; how profitable its existing business is; how much of its earnings it retains and
how much it pays out to shareholders; how efficiently it manages its assets; and how much financial
leverage it is willing to bear.
First, let us define what we mean by ‘growth’. A company’s growth can be measured by increases in its
market value, its asset base, the number of people it employs or any number of other metrics. For now,
let us imagine that a company establishes a growth target in terms of sales. Our experience suggests that
most companies define and measure growth targets in terms of sales, so we will use that convention as well.
That is, when we say that a company plans to grow by 10% next year, we mean that it hopes to achieve a
10% increase in sales revenue.
With sales growth in mind, think about what growth means for a company in terms of its balance sheet.
An increase in sales probably requires additional investments in assets. Certainly, we would anticipate
that increased sales volume would require additional investments in current assets, such as inventories
and receivables. Over time, increases in sales will also require new investments in fixed assets, such as
production capacity and office space. As a shortcut, let us assume that a company’s total asset turnover
ratio, the ratio of sales (S) divided by total assets (A), remains constant through time. In other words, any
increase in sales will be matched by a comparable percentage increase in assets. Because the balance
sheet equation must hold, increases in liabilities and shareholders’ equity must equal the increase in
assets. So how would we expect increases in liabilities and shareholders’ equity to come about?
In previous chapters we learned that most companies issue new ordinary shares very infrequently,
so we will rule that out as a potential source of new financing. As with inventories and receivables,
accounts payable should increase (higher sales volume means higher purchases). We might also expect
to see higher accruals and higher short-term liabilities of other types. Similarly, if a company’s business is
profitable then its equity account will increase (even if it does not issue any new shares) by the amount of
earnings it retains. Figure 16.1 illustrates that the growth in assets must equal growth in these liability
and equity accounts over time.Developing the Sustainable Growth Model
The sustainable growth model starts with a balance sheet identity. It then adds a few assumptions and
ultimately derives an expression that determines how rapidly a company can grow while maintaining
a balance between its outflows (increases in assets) and inflows (increases in liabilities and equity) of
funds. Specifically, the sustainable growth model assumes the following:1 The company’s only form of equity is from ordinary shares (E), and it will not issue new ordinary
shares next year.2 The company’s total asset turnover ratio, S/A, remains constant.
3 The company pays out a constant fraction, d, of its earnings as dividends.
4 The company maintains a constant assets-to-equity ratio, A/E.
5 The company’s net profit margin, m, is constant.
Consider a company that wants to increase sales next period by g per cent. If total assets in the
current period equal A, and if the total asset turnover ratio remains constant, then assets must increase
in the next period by gA. This represents a change in the left-hand side of the company’s balance sheet
next period – a change that must be balanced by an equal change on the right-hand side.sustainable growth model
Derives an expression that
determines how rapidly a
company can grow while
maintaining a balance
between its outflows
(increases in assets) and
inflows (increases in liabilities
and equity) of cash