Growth, overtrading and overcapitalization. Controlled and managed growth is critical to the future of a business.

Many businesses strive for growth.  There is a belief that fast growth is the best way to build a successful business.  However, is rapid growth the best option for business with relatively low cash and limited access to new external finance?



Overtrading

'Overtrading' is an imbalance between the work a business receives and its capacity to do it.  Overtrading is a symptom of fast-growing businesses, which chase sales and profitability at the expense of liquidity.

This is common in new businesses, which tend to offer long credit periods to customers in order to establish themselves in a new market.  At the same time many suppliers offer only short credit periods (or insist on cash payments) as the new business has no track record.  This gap between paying suppliers and receiving cash from customers is often financed via overdrafts.  Eventually overtraded businesses enter a negative cycle where banks will not extend their overdraft any further.  Growing interest costs and the associated debt means their financial status eventually reaches insolvency.  

"Yesterday is a cancelled check.  Today is cash on the line.  Tomorrow is a promissory note."



Overcapitalization

On the opposite end of the spectrum of overtrading is overcapitalization.  An overcapitalized business has excess assets, which are not being utilized effectively.  In essence it is not maximising returns in relation to the size of its assets and in particular its cash.  This is not so risky as overtrading but the money should be 

• used to finance long-term projects or 
• returned to shareholders.

Overcapitazation is often a symptom of a previously successful, mature businesses with minimal future growth prospects.



Finding the balance

It is difficult for a growing business to turn away sales, but success can kill a business as quickly as failure.

Controlled and managed growth is critical to the future of a business.

• Growth demands investment and only a certain level of growth can be financed by internally generated cash.  
• Further growth requires external investment and there's only so much money shareholders will commit and banks will lend in the short term.  

High growth rates are heady stuff and not very persistent over a series of years

The allure of strong growth has probably led more investors into temptation than anything else. 

High growth rates are heady stuff - a company that manages to increase its earnings at 15% for 5 years will double its profits, and who wouldn't want to do that?

Unfortunately, a slew of academic research shows that strong earnings growth is NOT VERY PERSISTENT over a series of years; in other words, a track record of high earnings growth does not necessarily lead to high earnings growth in the future. 

Why is this?

• Because the total economic pie is growing only so fast - after all, the long-run aggregate growth of corporate earnings has historically been slightly slower than the growth of the economy - strong and rapidly growing profits attract intense competition. 
• Companies that are growing fast and piling up profits soon find other companies trying to get a piece of the action for themselves.

The Dangers of Unmanaged Growth: What Lessons Should You Learn?

 

What Lessons Should You Learn?

 

The Dangers of Unmanaged Growth.

Let's say you get a huge promotion and raise at work. You look at everything you own and think about upgrading your lifestyle. Should you get a bigger house, hire a personal trainer, or replace all your clothes in one Neiman Marcus shopping spree?

• Before you adjust your lifestyle, you should think about how long the raise could last. Maybe you should wait a year or two and see if your higher income persists.
• And even if your company does well, what happens to your job when the rest of the country cuts back on expenses?

Just as with Iceland, in a globalized world, no person, company or even country is a self-contained and independent entity. Therefore, Iceland's troubles showed that thinking ahead, even in the best of times, is an important survival strategy.

Iceland's Near Collapse: What Can We Learn?

Iceland's Near Collapse: What Can We Learn?

by Reyna Gobel,MBA (Contact Author | Biography)

While it's common to hear of companies going bankrupt, many were shocked when the entire country of Iceland almost fell into a state of bankruptcy in 2008. How could a country get to this point? And, once there, what could be done to mitigate the problem? Read on for a cautionary tale's description of what preceded Iceland's near economic collapse.

Cause of the Crisis
During the mid-1990s, Iceland flourished. Business was booming as financial products such as bank loans, investments and entrepreneurship became Iceland's biggest export. The country's economic reach became greater than ever. In fact, when you walk into the posh Handley's toy store in London to buy a five-foot-high plush Kangaroo, you're standing in an Icelandic company's investment.

Other new things were shaping up for Iceland during this time as well. For the first time in history, Iceland established its own domestic stock market in 1985. The growing economy greatly improved income for citizens, and wages increase by 45% between 1995 and 2000.

But with much of the banks' capital being loaned outside of the country, Iceland became overly dependent on other countries' economies staying afloat and those countries' residents and businesses paying off their debt.

Iceland's problems really began when it became a victim of poor currency trading rates, called carry rates. When currencies dropped in other markets, the Icelandic krona's value fell catastrophically. (For more information on what causes a country's currency to fall, read What Causes A Currency Crisis?)

Impact on the Average Icelandic Citizen

•Skyrocketing Interest Rates. Banks and the Icelandic government - which was forced to nationalize to stabilize some of Iceland's banks - needed to raise capital. Banks raise capital either by selling stocks or bonds. Unfortunately, both options were impossible in this situation. The third option was to raise interest rates, which limits lending in difficult times and encourages people in other countries to once again invest in Iceland's banking systems in the hope of a high return on a now-risky investment. But for the average Icelander, this rate hike caused mortgage rates to skyrocket, hitting a key interest rate of 18% in October of 2008, the highest level in Europe.

•International Travel Woes. When a national currency and homeland banks aren't viewed as very stable, traveling outside of the country becomes difficult for citizens. This is because other countries will have issues with accepting large amounts of Icelandic krona as payment.

The Rescuers: The International Monetary Fund
The International Monetary Fund is an international organization of 186 countries that aims to help nations avert financial crises by providing loans to countries with balance of payment issues, along with technical assistance. In October 2008, IMF announced a $2.1 billion loan plan with Iceland with the goal of restoring confidence in the banking system. Iceland must also adhere to an IMF-supported economic program. By March 2009, conditions in Iceland appeared to be improving, although it was maintaining very stringent controls on the flow of capital. (Chances are you've heard of the IMF. But what does it do, and why is it so controversial? See What Is The International Monetary Fund?)

What Lessons Should You Learn?

•The Dangers of Unmanaged Growth. Let's say you get a huge promotion and raise at work. You look at everything you own and think about upgrading your lifestyle. Should you get a bigger house, hire a personal trainer, or replace all your clothes in one Neiman Marcus shopping spree? Before you adjust your lifestyle, you should think about how long the raise could last. Maybe you should wait a year or two and see if your higher income persists. And even if your company does well, what happens to your job when the rest of the country cuts back on expenses?

Just as with Iceland, in a globalized world, no person, company or even country is a self-contained and independent entity. Therefore, Iceland's troubles showed that thinking ahead, even in the best of times, is an important survival strategy. (For related reading, check out The Globalization Debate.)


•One Country's Problems Can Impact the Global Economy. In a world where global economies are as important as national economies, one country's woes can either echo across the world, or the world's woes can encroach on any country worldwide. Iceland's banks had account holders and investors in a variety of countries shivering out of fear of losing their money. (For information on the global economy read Taking Global Macro Trends To The Bank.)


•Government Oversight of the Banking Industry. After the U.S. credit crisis of 2007-2008, mortgage rates didn't rise above 18% as they did in Iceland. However, pension and mutual funds dropped rapidly in value, home foreclosure rates skyrocketed and banks lost money to the extent of needing federal bailouts. The situation in Iceland questions the balance between a deregulated banking system and securing the stability of financial institutions that provide most of the funds for citizens' personal and professional lives. Iceland's crisis, as well as the one in the U.S., suggests that a line has to be drawn showing exactly when and how to intervene and stabilize a financial crisis. (To learn more, read Free Markets: What's The Cost?)

Conclusion
Iceland went to the brink of bankruptcy due to unmanaged, rapid growth of the banking industry in the mid-1990s. Icelandic citizens deal with high interest rates and some difficulty using their currency in other countries. Learn from this unfortunate event, and avoid the chill of unmanaged growth by analyzing and planning for major purchases in your own life - because you never know when a financial ice storm will hit your personal economy.

by Reyna Gobel (Contact Author | Biography)

Reyna Gobel is a freelance journalist and self-professed financial geek, who realized in her finance classes that personal finances weren't nearly as complicated as she thought they'd be and set out to spread the word.Gobel is also the author of "CliffsNotes Graduation Debt: How To Manage Student Loans And Live Your Life", which will be hitting the shelves in March of 2010.

http://www.investopedia.com/articles/economics/09/iceland-bankruptcy.asp

Using PEG ratio: Not all growth is created equal.

As the risk increases, the PEG ratio of a firm decreases. When comparing the PEG ratios of firms with different risk levels, even within the same sector, the riskier firms should have lower PEG ratios than safer firms.

 

Not all growth is created equal. A firm that is able to grow at 20% a year, while paying out 50% of its earnings to stockholders, has higher quality growth than another firm with the same growth rate that reinvests all of its earnings back. Thus, the PEG ratio should increase as the payout ratio increases, for any given growth rate.

As with the PE ratio, the PEG ratio is used to compare the valuations of firms that are in the same business.  The PEG ratio is a function of:

• the risk,
• growth potential and
• the payout ratio of a firm.

http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf

Bad Growth

Bad Growth

Bad growth is not confined to mergers and acquisitions lacking strategic rationale. Price-cutting to gain market share without a corresponding decrease in costs can also lead to disaster.

Some businesses are capital intensive with high fixed costs and a high breakeven point, for example, the building-materials industry. Cutting prices to gain significant market share maybe successful at least initially. However, the competition had no choice but to respond in kind, since a loss of market share in this high-fixed-cost industry means a loss of both cash flow and profitability. The end result of all that price cutting caused industry revenue and profits to shrink, which obviously, affected every business in the same industry. It may take some time to restore equilibrium to the business.

Cost cutting could have been succesful to gain market share if the company had improved productivity and offered higher-quality products and creating a better cost structure, ahead of the competition. With lower costs and higher-quality products, it would have been possible to cut prices and build market share while maintaining margin. Another approach could have tried to search out the most profitable segments of the market and/or become the industry's innovator.

With no intrinsic competitive advantages, the only result of price cutting was that everyone in the industry suffered, not without its consequences to the managers and management too.

Buying growth through uneconomic price discounting

Gaining market share by giving some customers unusually favourable credit terms - terms that result in your losing money on every sale - is another example of bad growth. It never works long term.

Subsidizing buyers' purchases of your product by charging them little or no interest on the financing options you offer them, or by giving them an extended period until they have to pay you, may spike sales in the short term, but it is never effective as a long-term growth strategy.

In these situations, companies are able to record revenues and profits in accounting terms, and managers get their bonuses for meeting targets, but at the end of the day a cash crisis arises and huge write-offs ensue.

How to Tell Good Growth from Bad Growth

How to Tell Good Growth from Bad Growth

All top-line growth is not created equal. History has shown that most mergers and acquisitions do little to help the long-term health and revenue growth of an organization. Growth that uses capital inefficiently is not the way to go.

How can you tell good growth from bad?

How good growth builds value

Growth of any kind increases revenues. Good growth not only increases revenues but correspondingly improves profits and is sustainable over time. It is primarily organic (internally) generated from the ongoing operations and business of the company and is based on differentiated products and services that meet new or previously unmet consumer needs.

Good growth is thus growth that is profitable, organic, differentiated, and sustainable (PODS). Good growth builds shareholder value over time. In contrast, bad growth destroys shareholder value.

Mergers and acquisitions, a primary example of bad growth, are often based on myopic visions of synergy that have no basis in the reality fo the market place. Instead of 4 plus 4 equaling 10, as promised when the deals are announced, more often than not 4 plus 4 winds up equaling 5 or 6. It is true that a large number of mergers and mega-acquisitions result in one-shot cost synergies - usually cost savings from the elimination of duplication with the merged enterprise - but seldom in an improved rate of revenue growth that is sustainable for the long run.

Compared with growing through a string of major acquisitions, good growth offers better returns over time, is less risky, and saves companies from crippling high debt and cash crises such as those faced by Vivendi and AOL Time Warner.

Vivendi acquired (among other things) Universal Studios, Blizzard Entertainment, and Def Jam. The problem? Vivendi overpaid and used debt to pay for most of those high-priced acquisitions. While the companies it bought were making money, Vivendi as a whole plunged into the red, after taking into account the repayment of interest on the billions of dollars it borrowed. The financial condition of the company became so acute that many wondered if it would survive.

Of course, not all acquisitions are bad. There are times when scale (i.e., your overall size in relation to competitors) matters and it can be impossible to compete against industry giants without it.

Phillips and Conoco were both relatively small fish in the energy market. They were both growing but they were at a huge competitive disadvantage versus ExxonMobil or BP. The Conoco-Phillips merger in 2002 (the new company is called ConocoPhillips) took out costs, and the integration of the two companies has been extremely successful. They have built on each other's strengths.

Similarly, there are times when an industry goes through a consolidation wave. At those moments, you either get bigger or find yourself at a disadvantage.

But, overall, organic growth remains the way to go. It results in a better price-earnings ratio so that when an industry undergoes consolidation, this strength provides a company with the upper hand in making appropriate acquisitions against its competition. The end result is a company with additional scale and scope and greater credibility to go to the next level.

****Seek good growth and avoid bad growth

I love to invest in good quality long-term profitable growth businesses available at reasonable or bargain prices. Yet, growth can be good and can also be bad. Let's take a look.

A framework for distinguishing good from bad growth is a crucial element in generating revenue growth.

Good growth:

• not only increases revenues but improves profits,
• is sustainable over time, and
• does not use unacceptable levels of capital.
• is also primarily organic (internally generated) and
• based on differentiated products and services that fill new or unmet needs, creating value for customers.

The ability to generate internal growth separates leaders who build their businesses on a solid foundation of long-term profitable growth from those who, through acquisitions and financial engineering, increase revenues like crazy but who create that growth on shaky footings that ultimately crumble.

Many acquisitions provide a one-shot improvement, as duplicative costs are removed from the combined companies. But few, if any, demonstrate any significant improvement in the RATE of growth of revenues.