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External Financing and Growth

Financial plans force managers to be consistent in their goals for growth, investments, and financing. The nearby box describes how one company was brought to its knees when it did not plan sufficiently for the cash that would be required to support its ambitions. Financial models, such as the one that we have developed for Executive Fruit, can help managers trace through the financial consequences of their growth plans and avoid such disasters. But there is a danger that the complexities of a full-blown financial model can obscure the basic issues. Therefore, managers also use some simple rules of thumb to draw out the relationship between a firm`s growth objectives and its requirement for external financing.

Recall that in 1999 Executive Fruit started the year with $1,000,000 of fixed assets and net working capital, and it had $2,000,000 of sales. In other words, each dollar of sales required $.50 of net assets. The company forecasts that sales next year will increase by $200,000. Therefore, if the ratio of sales to net assets remains constant, assets will need to rise by .50 200,000 = $100,000.2 Part of this increase can be financed by retained earnings, which are forecast to be $36,000. So the amount of external finance needed is

Required external financing = (sales/net assets) increase in sales Ј retained earnings

= (.50 200,000) Ј 36,000 = $64,000

Sometimes it is useful to write this calculation in terms of growth rates. Executive Fruit`s forecasted increase in sales is equivalent to a rise of 10 percent. So, if net assets are a constant proportion of sales, the higher sales volume will also require a 10 percent addition to net assets. Thus

New investment = growth rate initial assets

$100,000 = .10 $1,000,000

Part of the funds to pay for the new assets is provided by retained earnings. The remainder must come from external financing. Therefore,

Required external financing = new investment Ј retained earnings = (growth rate _ assets) Ј retained earnings

This simple equation highlights that the amount of external financing depends on the firm`s projected growth. The faster the firm grows, the more it needs to invest and therefore the more it needs to raise new capital. In the case of Executive Fruit,

Required external financing = (.10 $1,000,000) Ј $36,000

= $100,000 Ј $36,000

= $64,000

If Executive Fruit`s assets remain a constant percentage of sales, then the company needs to raise $64,000 to produce a 10 percent addition to sales.

The sloping line in Figure 1.20 illustrates how required external financing increases with the growth rate. At low growth rates, the firm generates more funds than necessary for expansion. In this sense, its requirement for further external funds is negative. It may choose to use its surplus to pay off some of its debt or buy back its stock. In fact, the vertical intercept in Figure 1.20, at zero growth, is the negative of retained earnings. When growth is zero, no funds are needed for expansion, so all the retained earnings are surplus.

As the firm`s projected growth rate increases, more funds are needed to pay for the necessary investments. Therefore, the plot in Figure 1.20 is upward-sloping. For high rates of growth the firm must issue new securities to pay for new investments. Where the sloping line crosses the horizontal axis, external financing is zero: the firm is growing as fast as possible without resorting to new security issues. This is called the internal growth rate. The growth rate is ¬internal ­ because it can be maintained without resort to additional external sources of capital. Notice that if we set required external financing to zero, we can solve for the internal growth rate as

Internal growth rate = retained earnings assets

Thus the firm`s rate of growth without additional external sources of capital will equal the ratio of retained earnings to assets. This means that a firm with a high volume of retained earnings relative to its assets can generate a higher growth rate without needing to raise more capital.

We can gain more insight into what determines the internal growth rate by multiplying the top and bottom of the expression for internal growth by net income and equity as follows:

Internal growth rate = retained earnings _ net income _ equity net income equity assets = plowback ratio _ return on equity_ equity assets

A firm can achieve a higher growth rate without raising external capital if (1) it plows back a high proportion of its earnings, (2) it has a high return on equity (ROE), and (3) it has a low debt-to-asset ratio. Instead of focusing on the maximum growth rate that can be supported without any external financing, firms also may be interested in the growth rate that can be sustained without additional equity issues. Of course, if the firm is able to issue enough debt, virtually any growth rate can be financed. It makes more sense to assume that the firm has settled on an optimal capital structure which it will maintain even as equity is augmented by retained earnings. The firm issues only enough debt to keep its debt- equity ratio constant. The sustainable growth rate is the highest growth rate the firm can maintain without increasing its financial leverage. It turns out that the sustainablegrowth rate depends only on the plowback ratio and return on equity:3

sustainable growth rate = plowback ratio _ return on equity

SUSTAINABLE GROWTH RATE Steady rate at which a firm can grow without changing leverage; plowback ratio return on equity.