Profit margin an increase in profit margin will

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Unformatted text preview: hat we have is that a firm’s ability to sustain growth depends explicitly on the following four factors: 1. Profit margin. An increase in profit margin will increase the firm’s ability to generate funds internally and thereby increase its sustainable growth. 2. Dividend policy. A decrease in the percentage of net income paid out as dividends will increase the retention ratio. This increases internally generated equity and thus increases sustainable growth. 3. Financial policy. An increase in the debt-equity ratio increases the firm’s financial leverage. Because this makes additional debt financing available, it increases the sustainable growth rate. 4. Total asset turnover. An increase in the firm’s total asset turnover increases the sales generated for each dollar in assets. This decreases the firm’s need for new assets as sales grow and thereby increases the sustainable growth rate. Notice that increasing total asset turnover is the same thing as decreasing capital intensity. The sustainable growth rate is a very useful planning number. What it illustrates is the explicit relationship between the firm’s four major areas of concern: its operating efficiency as measured by profit margin, its asset use efficiency as measured by total asset turnover, its dividend policy as measured by the retention ratio, and its financial policy as measured by the debt-equity ratio. EXAMPLE 3.7 Profit Margins and Sustainable Growth The Sandar Co. has a debt-equity ratio of .5, a profit margin of 3 percent, a dividend payout ratio of 40 percent, and a capital intensity ratio of 1. What is its sustainable growth rate? If Sandar desired a 10 percent sustainable growth rate and planned to achieve this goal by improving profit margins, what would you think? ROE is .03 1 1.5 4.5 percent. The retention ratio is 1 thus .045(.60) [1 .045(.60)] 2.77 percent. .40 .60. Sustainable growth is For the company to achieve a 10 percent growth rate, the profit margin will have to rise. To see this, assume that sustainable growth is equal to 10 percent and then solve for profit margin, PM: .10 PM PM(1.5)(.6) [1 PM(1.5)(.6)] .1 .99 10.1% For the plan to succeed, the necessary increase in profit margin is substantial, from 3 percent to about 10 percent. This may not be feasible. CHAPTER 3 Financial Statements Analysis and Long-Term Planning 77 ros82361_ch03.indd 77 5/27/08 10:15:11 AM Confirming Pages Given values for all four of these, there is only one growth rate that can be achieved. This is an important point, so it bears restating: If a firm does not wish to sell new equity and its profit margin, dividend policy, financial policy, and total asset turnover (or capital intensity) are all fixed, then there is only one possible growth rate. One of the primary benefits of financial planning is that it ensures internal consistency among the firm’s various goals. The concept of the sustainable growth rate captures this element nicely. Also, we now see how a financial planning model can be used to test the feasibility of a planned growth rate. If sales are to grow at a rate higher than the sustainable growth rate, the firm must increase profit...
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This note was uploaded on 10/28/2009 for the course FINA 505 taught by Professor Deborahcernauskas during the Summer '09 term at Northern Illinois University.

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