Entrepreneural Issues

Chapter 3
Financial Forecasting: Sustainable Growth and Ownership Control

Small, closely held firms often find it difficult to sell new shares. Furthermore, even if the owners could find new shareholders, the owners may be reluctant to sell more shares because of worries about losing control of the firm. Thus, an important question for such entrepreneurs is: How fast can the firm grow without having to sell new shares? To find this sustainable growth rate (g*), assume that sales (S) as well as all assets (A) grow at this rate (g*) and the firm’s net profit margin ratio (NPM), debt-to-equity ratio (D/E), and retention rate (r) (additions to retained earnings/EAT) remain constant.

The sustainable growth rate (g*) is the solution to Equation 3N.1:

Solving Equation 3N.1 for g* and then doing some algebraic rearranging yields

where ROE is return on equity .

If a firm has no debt, the sustainable growth formula simplifies to

where ROI = Earnings after taxes/Total assets.

This is because ROI = ROE when a firm has no debt. Sometimes this simplified expression has been used even for firms with debt and referred to as the internal growth rate that requires no external financing. In this case, the firm’s debt-to-equity ratio would be declining over time. It is hard to imagine that a firm’s profit margin would remain constant (a model assumption) as interest charges become a declining percentage of sales. Hence, we recommend using this simplified formula only for firms with no debt.

Below are the simplified balance sheet and income statement for 20X6 of the LaGrange Furniture Store, a small family-owned business.

We can calculate the firm’s return on shareholders’ equity and retention rate from its balance sheet and income statement as

ROE = $180,000/$600,000 = 0.30 or 30% and r = $120,000/$180,000 = 2/3

Substituting into Equation 3N.2 yields the firm’s sustainable growth rate:

g* = [0.30 ¥ (2/3})]/[1 – {0.30 ¥ (2/3}}] = 0.20/.80 = 0.25 or 25%

Note also that the net profit margin ratio and debt-to-equity ratio for this firm are

NPM = $180,000/$1,200,000 = 0.15 or 15%
D/E = ($200,000 + $100,000)/$600,000 = 0.50

To see that g* is the sustainable growth rate, examine the firm’s pro forma balance sheet and income statements for 20X7. These statements were generated by growing all balance sheet and income statement items by the firm’s sustainable growth rate of 25%.

[Sustainable growth rate The rate at which a firm can grow without being required to sell more equity securities.]

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