Balance Sheet Growth

Company managers operate to create and capture value. This value is linked to balance sheet growth. The sources of growth funds are equity, debt, and operating profits. Asset growth can be financed by either venture investment or by earnings power expansion.

Venture investment occurs when profits are not sufficient to finance necessary asset growth. Instead managers must raise funds from equity or debt investors with a plan to reach break-even cash flow in the future. The financial plan for a venture investment consists of a break-even cash flow forecast.

When a venture achieves break-even cash flow, and consistently generates profits from normal operations, the company is then considered a self-sustaining business. But if the company makes purchases on credit, makes sales on credit, and attempts to grow sales too rapidly, then it will run out of cash. Principles of cash managemenent linked to sales growth are described in The Cash Flow Problem Solver: Common Problems and Practical Solutions. [1]

Earning power expansion occurs when profits from normal operations are sufficient to finance necessary asset growth. In 101 Business Ratios Sheldon Gates describes the Affordable Growth Rate (AGR). This ratio assumes, on average, that sales may grow no faster than assets, and that lenders will extend credit for sales growth if the debt to equity ratio is relatively constant. Thus a company's growth is affordable only to the extent that profits are available to provide the funds. For AGR the debt to equity ratio is constant because equity grows at the rate of accumulated profits. [2]

According to Greenwald and Kahn, authors of Competition Demystified, the strategy of sales expansion is most often successful when the company uses earning power to expand into markets where it enjoys competitive advantages. Thus earning power buys even more earning power in a company with proven capacity to create and capture value. [3]

References

[1] The Cash Flow Problem Solver: Common Problems and Practical Solutions, Brian E. Milling, iUniverse, 2000.

[2] 101 Business Ratios - Affordable Growth Rate, Sheldon Gates, McLane Publications, 1993.

[3] Competition Demystified, Bruce Greenwald and Judd Kahn, Portfolio (Penguin Group), 2005.