Question

One of a CFO's most important responsibilities is to help his/her company in managing growth. This week's readings refer to two growth rates, an internal rate and a sustainable rate of growth. What does each rate mean? Why do we, as CFO's, need to understand the implications of both the internal and sustainable rates of growth? What are the four primary determinants of a company's growth and how does each factor add to or limit a company's growth potential?

Answer 1

The internal rate of growth is the maximum rate at which the firm can grow without resorting to external financing. It is defined as retained earnings divided by the total assets.

Sustainable growth rate is defined as the product of the firm’s return on equity multiplied by the percentage of profits that is reinvested in the firm.

As a CFO, it is essential to understand sustainable growth rate and internal growth rate to estimate the maximum limits of growth that the firm can have without resorting to external financing in the form of debt or equity. And if still higher growth rates are required, then the firm should plan for external financing.

The four major factors determining a firm’s growth are:

• Profit margin which is an indicator of operating and process efficiency of the firm. Higher profit margins implies better growth prospects.
• Turnover of assets is also an indicator of growth. With higher turnover of assets, the asset utilization is higher thus implying better growth.
• Leverage also optimizes the cost of capital. So an optimal capital structure promotes growth by allowing the firm to take on investments at an attractive cost of capital.
• The dividend policy of the firm should be appropriate such that in the face of growth opportunities, most of the fund should be reinvested to take the advantage of possible opportunities rather than distributing profits among shareholders.