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The Growth Indicator
- Increasing Efficiency
The simple framework to assess the need for growth can
be made more meaningful, by incorporating criteria that matter.
As discussed in the first article, the SFG rate helps a company
in identifying optimal operational levels for generating profits.
In addition to achieving a growth in profits, the framework
gives managers practical insights into how efficiently their
operations are running; how profit margins fuel faster growth,
which product lines and customer segments hold the greatest
growth potential, and what kinds of businesses might be attractive
investment targets.
Adding complexity…
In the first article, the SFG model assumed that the operating
cash cycle included all the cash flows involved in generating
sales. In addition, as there were no non-cash expenses, profits
equalled cash at the end of each cycle. However, the assumption
was simplistic as the effect of income tax and depreciation
was not taken into consideration.
Impact of income tax on SFG rate…
If income tax is taken into consideration, two difficulties
arise. One, taxes are not paid uniformly over a company's operating
cycle. Besides, their calculation includes non-cash expenses
such as depreciation. For instance, 40% of pre-tax profits are
paid quarterly in income taxes. We further assume that taxes
are paid in the second half of the operating cycle. Therefore,
in the first half of the cycle, cash must be maintained not
only for cost of sales and operating expenses , but also for
payment of income tax. If sales volumes are constant and cash
outlays are increased, it would reduce the SFG rate.
Impact of depreciation and asset replacement on SFG rate…
Cash resources maintained for asset replacement and updating
usually offset depreciation. During financial years when no
asset replacement takes place, the SFG rate increases, since
depreciation allowances simultaneously reduce taxes due, while
yielding more cash from operations. However, if new assets are
acquired for maintaining the current sales level, the SFG rate
falls, as cash that is invested for asset replacement exceeds
the cash generated from the tax shield.
Impact of capital expenditure…
In the previous article, we assumed that the company cited in
the example had enough capacity to accommodate an increase in
sales, without increasing its fixed assets, or undertaking aggressive
marketing or R&D efforts. However, in reality, every company
has to invest in fixed asset replacement and updating of business
processes, owing to asset wear and tear. Or, it may have to
undertake a major promotional activity to increase the demand
for its products. In such cases, a portion of the cash generated
in each operating cycle must be set aside to fund expenses that
span a number of cycles.
Investing in additional fixed assets… When the company
makes a huge investment in fixed assets, it has the option of
writing off this amount fully in one operating cycle or over
multiple cycles. In the first case, cash outlay increases significantly,
reducing the SFG rate at the time of investment. In the second
case, the impact of the huge cash outlay is not very significant
on the SFG rate.
After making a capital investment, the company can achieve
the original SFG rate, if the operating expenses and working
capital levels remain constant. However, if the new investment
reduces the cost of sales or operating expenses, the growth
rate would increase.
Investing in R&D and Marketing… A company that invests
in R&D and treats the expense as capital expenditure is
likely to have a reduced SFG rate. However, if the company decides
to treat the expense as current expenditure, and reveals it
in the financial statements of the current operating cycle,
the taxable income reduces. The level of operating expenses,
and the sales volumes remains constant in the immediate cycle.
This leads to a decline in the SFG rate.
Impact of different product lines within a business…
Different product lines, customers and business units exhibit
varying cash and operating features. For instance, some customers
may need extended terms of credit thereby requiring greater
investments in working capital. Others may demand volume discounts.
Cash has to be mapped with such adjustments, but this in turn
affects the SFG rate.
SFG rate…a bridge between operations and asset management…
Operating management decisions focusing on the income statement;
and asset management decisions focusing on the balance sheet,
are made by different managers. The SFG framework helps bring
these discrete decisions on a common platform for formulation
of financial and operating strategies affecting growth.
Related reading:
"How Fast Can Your Company Afford to Grow?" Churchill.C.
and Mullins.W: Harvard Business Review.
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