June 27, 2017

Article 2.8


According to Dun and Bradstreet, business failures for the first six months of 1991 increased by about 50% over the first half of 1990. Based on past recessionary data and patterns, these failure statistics will not peak until about six months past the recent U.S. recession's bottom.

We can learn several things from business failures:

  1. Most businesses that fail or come close to it during tough times actually planted the seeds for their disasters during economically good times.
  2. Although there are many ways to mis-manage a business, the number one reason cited for business failure is: "Business was too good; we grew too fast; we ran out of cash to pay the bills."
  3. Running out of cash may seem naive, but remember that 90% of all firms in the U.S. are less than a million dollars in sales and have less than 50 employees. The CEO-owners of most "small businesses" must be generalists who are often strong in marketing and industry knowledge, but finance can be an afterthought. Most bookkeepers and accountants who assist small businesses are not financial planners either; they can be as surprised as the CEO when the firm runs out of cash while reporting steady and growing profits after tax (PAT).
  4. The central problem for the fast-growing firms is that sales, and the assets to support the sales, both have been growing at a steadily faster rate than the reinvested PAT which is a significant part of growth capital. A financial guideline that links sales, assets, and PAT together is the "long-term, sustainable growth rate (LTSGR) formula." For a firm, the LTSGR is equal to the firm's average return on investment (ROI) which is reinvested or retained within the business over a given time period. (The ROI is equal to PAT divided by "shareholder's investment, equity or net worth" - all are synonyms.)


Before further explanation, we must review two key assumptions which are that: the firm will maintain a constant ratio of sales to assets which is also called "asset turnover"; and, the firm will maintain a constant ratio of other people's money in the firm to shareholder's money both of which are on the "liabilities" side of the balance sheet. Having a constant asset turnover ratio assumes that as the sales grow the assets to support the sales will grow at the same rate. From a timing viewpoint, asset growth (and other overhead expense investments) usually precede both sales and profits-in-hand growth to help to create and fulfill new sales demand.

For example, consider a firm that grows its sales at a 15% compounded annual rate for 5 years which will roughly double its size. During those same years, the firm would have to earn PAT that would yield on average a 15% ROI. And then, 100% of those profits would have to be reinvested within the business, to maintain the same "leverage ratio" of debt (other people's money) to equity (the shareholders' money) within the business.

Because of "double-entry accounting", both assets and liabilities equal the total amount of money that is in a business at a specific time. "Assets" tell us what form the money is in at that moment, such as inventory, receivables, etc, while "liabilities" tell us who's money is in the business - the suppliers, the bank, etc. If sales, assets and liabilities all are growing at 15% in our example, then shareholder's equity must grow at 15% to stay in a constant ratio with the other liabilities which would also be growing at 15%.

If an ambitious manager doesn't know all of this, he or she might try to grow at a 25% rate which would double volume and assets in roughly three years. The easiest way to grow fast, however, is to be aggressive with prices, terms, extra free services and forward-investing in salespower expense, all of which depress earnings. Let's assume, consequently, that the firm makes an average ROI of only 10% which is all reinvested.

This firm's assets and liabilities will be growing at a 25% rate to create and support sales, but shareholder's equity, a key part of total liabilities, will be growing at only 10%. The other parts of total liabilities must, therefore, grow faster than 25% to make up for the equity growth shortfall. These unbalanced growth rates of the parts will cause the ratio of other people's money to shareholders' money to increase.

If a firm's leverage increases steadily, it can be manageable as long as operating profits can cover debt and lease obligations. At some point, however, a bank will stop lending because the leverage is too high. Then, a firm can't borrow at prime to take supplier discounts worth taking, so the suppliers become bigger lenders through their extended trade credit until they put the firm on credit hold. If the firm can't get supplies, then they can't serve their customers. Profitable sales are lost; profits to service bank debt become inadequate; and the financial crisis has arrived.

Another scenario for an over-leveraged firm is when a recession arrives. Because lots of customers may start buying less, sales, margins and profits drop faster than costs can be cut. The firm then can't meet interest payments and must default on debt obligations.

Increasing leverage raises the risk of financial crunches and failure. If a firm grows faster than their LTSGR, then there will have to be an eventual, perhaps traumatic correction period.

Some firms have the opposite conditions of slow growth and high profitability. If they reinvested all of the profits, they will pay off all debts, take all discounts, buy assets for cash, and accumulate extra cash to invest in securities. Private firms like this often go to a sub-S legal status and pay-out excess profits to shareholders as once taxed income.


Growth is a positive thing for a business if it is done with matching, reinvested profitability that complies with the LTSGR formula. The problem is with rapid growth goals usually set for ego reasons and supported by obsolete rationalizations such as: needing clout and visibility with suppliers; achieving low-cost economics with economies of scale; and needing to be #1 to impress customers.

Today volume is vanity and profits are sanity. If suppliers are pushing for volume increases, ask them to stop wishfully thinking and suggest where and how additional, profitable market share can be found. Customers buy from the supplier that meets their needs the most perfectly and consistently; small firms with tightly focused niches often have greater absolute profits than unfocused, volume-driven competitors with 2 to 4 times the sales.

By best serving targeted customers, a firm will grow faster than mediocre competitors by retaining happy accounts at a greater rate than the competitors. Make customer satisfaction and retention the first priority and growth will occur as a by-product.

A growing firm must also go through life-stage plateaus where it must be reorganized to support the next stage of growth. These plateaus should be anticipated and carefully executed to avoid deteriorating performance later (?) It is harder to win back customers that you let down than it is to win one initially. The thoughtful growers will, like the hare, outperform the speed-obsessed rabbits in the long run.

Recessions cause painful cash-crunches and business failures. But in every crisis or negative event, there is usually a lesson. Let's heed the LTSGR guideline for our own firms and be careful with fast-growing suppliers and customers who seem to be growing for a fall.


©Merrifield Consulting Group, Inc. Article 2.8