16: Financial PlanningInterpreting the Sustainable Growth Model
It is just as important to understand what the sustainable growth model does not say as it is to grasp
what it does say. From the previous calculation, should we assume that Virgin Australia managers should
have set as their company’s growth target an increase in sales of 2.5%, equal to the sustainable growth
rate? Not at all. Virgin Australia managers should have decided what rate of growth would maximise
shareholder wealth, and then they should have used the sustainable growth model as a planning device
to help them prepare for the consequences of their growth plans. Suppose that Virgin Australia decided
it was best for its shareholders if the company grew at a more rapid rate than 2.5%. In order to do this,
Virgin Australia would need to alter one or more of the baseline assumptions of the model. It could have
found ways to increase its profit margin, its asset turnover or its leverage. Since Virgin Australia did not
pay dividends at that time, it could not use a dividend cut to increase growth.
The sustainable growth model gives managers a shorthand projection that ties together growth
objectives and financing needs. It provides hints about the levers that managers must pull in order to
achieve growth above the sustainable rate. The model also identifies some financial benefits of growing
more slowly than the sustainable rate. A company that expects to grow at a rate less than g* can plan to
reduce leverage or asset turnover, or to increase dividends. Again, we emphasise that the model does not
say anything about how fast the company should grow.
The sustainable growth model also highlights tensions that can develop as companies pursue
multiple objectives simultaneously. We have seen that one way to finance faster growth is to increase
leverage, so the goals of increasing sales and maintaining the current degree of leverage may be difficult
to achieve simultaneously. For the company to achieve faster sales growth, the marketing group may
agree that it should offer a wider array of products. Doing so may result in lower inventory turnover
and reduced total asset turnover. If the company is unwilling to increase leverage, and if expanding the
product line means reducing asset turnover, then meeting the sales target will depend on improving
profit margins or cutting dividend payout. Compensation issues may further cloud the evaluation of
competing objectives: for example, the compensation of the vice-president of marketing may be tied to
generating additional sales volume, whereas the CFO’s compensation may depend on maintaining the
company’s credit rating.
The primary advantage of the sustainable growth model is its simple way of linking various aspects of
financial planning. However, the financial planning process generally involves more complex projections.
These projections are usually embodied in a set of pro forma income statements and balance sheets that
companies use to provide a benchmark against which to judge future performance.16-2b PRO FORMA FINANCIAL STATEMENTS
Periodically, companies produce pro forma financial statements, which are forecasts of what they expect
the income statement and balance sheet to look like a year or two ahead. Occasionally, companies use
these statements to communicate their plans to outside investors (such as at the time of an IPO or
earnings announcement). Most of the time, however, managers construct pro forma financial statements
for purposes of internal planning and control. By making projections of sales volume, profits, fixed asset
requirements, working capital needs and sources of financing, the company can establish goals to which
compensation may be tied. The company can also predict liquidity requirements with enough lead time
to arrange additional financing when needed.LO 16.3
pro forma financial
statements
A forecast of what a company
expects its income statement
and balance sheet to look like
a year or two ahead