Business Alchemy 101 Lesson 14–Affordable Growth Rate (Application)

Affordable Growth Rate by itself does not really give us enough of a story for us to know if the resulting ratio is good or bad.

If you are able to track the AGR over several periods, then you can start to make some sense of whether your AGR is good or bad.  However, it is only when you compare the AGR to the Sales Growth Ratio that you can really start to make sense of your situation.

The key to understanding if your growth is affordable is to take a look at the rate your sales are growing and compare that growth over time.  If your sales are increasing over time, but your AGR is not growing comparably, that means that you are operating less efficiently as you continue.  In other words, if your sales growth is ten percent higher this period than the previous period, then your AGR should be 10% higher this period than it was last period.

Less efficient operation means that less dollars are going back into the pockets of the shareholders of the company.  Since the whole purpose of investing in a company (even if you are the sole shareholder and owner of the company) is to create a profit and put more money into your pocket than you put out, this is not sustainable growth.

Unfortunately, this is nothing more than a giant, flashing, neon sign telling you there is a problem, it does not point out where you can find the problem.  When you can recognize that you are having this problem, then you really need to get into some horizontal analysis and find out where the inefficiencies are popping up inside the company.

Even using the equity to purchase assets to increase efficiency, pay down long-term debt or pay dividends should not affect the ratio over time.  This is because you are always using the Equity from the previous period’s Balance Sheet to determine the ratio.

Quite the contrary, this ratio will help you to determine if your actions from the previous period have helped to improve or maintain your efficiency and keep pace with your Sales Growth.

Sales growth is necessary to a business and having affordable growth gives you a solid foundation and as you already know…

…Your business THRIVES on a solid FOUNDATION!!!

Business Alchemy 101 Lesson 14–Affordable Growth Rate (Part Three)

Continuing on with the AGR discussion, let’s now modify the equation a little.

First, this ratio is another one that is commonly viewed as a percentage, so we will multiply the result by 100 to more easily express it as a percentage.

Second, though I think it goes without saying, we want to make sure that we are subtracting taxes from the profit in the equation.  We do this because we do not want our profit inflated.  We want to back our taxes from our current earnings, not our equity, so this is expressed as Profit After Taxes.

The last clarification is that we need to subtract any intangible assets from our company.  We cannot really tap into intangibles such as Goodwill in order to fund a company, so this last expression is written as Tangible Equity from Last Year.

Therefore, the new equation is:

100 X (Net Retained Profit After Taxes/Tangible Equity from Last Year)

Your business THRIVES on a solid FOUNDATION!!!

Business Alchemy 101 Lesson 14–Affordable Growth Rate (Part Two)

AGR is a horizontal analysis tool because you are going to use numbers from two different years and compare these numbers to determine how well supported your growth is currently.

Additionally, you are going to use one number from the Profit and Loss Statement and one from the Balance Sheet.  This is because traditionally the profit from any year is not added to the Balance Sheet until the year (or period) is closed out.

The simplified equation is:

Profit / Equity from Last Year

Things may become confusing if you follow our rules on understanding ratios.  For instance, which is the good guy and which is the bad guy?  They both look like good guys.

The answer to this quandry comes from answering the second question first.  We are looking at this battle scenario from the point of view of the Equity from Last Year so do we want the number to be higher–meaning that Equity loses to Profit because each dollar of Equity has to wipe out more dollars of Profit–or do we want the number to be lower–meaning that Equity wins  because each dollar of equity has to wipe out fewer dollars of Profit?

Remember that this ratio is like a rubber band and the higher the number, the more the rubber band is being stretched.  With this in mind, we can answer the questions we need to in order to understand the ratio.

The quick answer is that a lower AGR is better and Equity from Last Year is our champion.  However, the important number is not the AGR itself, but instead the change in AGR from one period to the next.  If the Sales Growth Ratio is increasing rapidly and our AGR is growing rapidly, our growth is not supported by equity.

The important thing to keep in mind is that as a company grows, the growth has to be funded somehow.  If the company has an increasing profit, and the AGR is increasing more than the profit, this can be a sign that additional funding for the growth may be necessary to pursue from outside sources.

If the AGR remains steady or drops and the profit of the company is increasing, this means you have a solid capital foundation and…

Your business THRIVES on a solid FOUNDATION!!!

Business Alchemy 101 Lesson 14–Affordable Growth Rate (Part One)

Affordable Growth Rate, or AGR, is best illustrated with an elastic.  Elastics are typically used to hold things together.  The key characteristic of an elastic is its stretch.

Similarly, AGR is used to hold a business together and the characteristic it measures is how far a company can stretch.

As a business increases it’s sales, it will also need more product and/or hours to provide the goods and services.  Imagine this as an ever increasing stack of books that you will need to put an elastic around.

So the question is regarding the number of books that you can hold together with an elastic, or how far the elastic will stretch before it breaks.  This is the question measured and answered by AGR.

AGR is one way to measure how much growth can be supported by the money and assets that the company currently has available to them in the form of equity before having to pursue financing from outside sources such as from loans or an additional sale of stock.  This sustainable growth is exceeded when the elastic band breaks.

The elastic band may break at different percentages for different companies so it is important to measure this ratio frequently and compare it to performance in the past.  This of course is easily done with quality bookkeeping and as you know…

Your business THRIVES on a solid FOUNDATION!!!

Business Alchemy 101 Lesson 12–A Word on Ratios and Going Vertical or Horizontal (Part Three)

One last note on understanding ratios.  It is important to understand the difference between vertical and horizontal comparisons with ratios.

Suppose you were to take your Profit and Loss Statements for the last three years and place them on the table next to each other.  If you wanted to use a highlight marker to mark the Gross Revenues for each statement, you would start at the statement on the left, find the Gross Revenue and mark it and then you would move HORIZONTALLY to the next statement, find the Gross Revenue, mark it and move to the last statement in the same manner. Continue reading

Business Alchemy 101 Lesson 13–Sales Growth Ratio (Application)

The Sales Growth Ratio is important to track so that you can better understand your sales and see if there is a weakness in your sales.  This number can be compared to the same ratio from previous years or across companies within the same industry in order to make conclusions about the health of your sales.

If you are trying to grow your company, you will want a higher Sales Growth Ratio.  Use this ratio to incentivise your sales team and to make decisions about your marketing and sales strategies.

There are cases in which you may not want a strong Sales Growth Ratio.  If you are struggling with processes, fulfilling customer orders and customer satisfaction, you may prefer to adjust your sales to only the most profitable clients and instead spend some time and money on improving the internal structure of your company before pushing forward.

These ideas are another reason why it is important to have information at hand to make your decisions instead of just making guesses about what your company needs.  Remember…

…Your business Thrives on a solid Foundation!!!

 

Business Alchemy 101 Lesson 13–Sales Growth Ratio (Part Three)

The Sales Growth Ratio equation can be expanded, and usually is in its more common form.  The expanded equation is:

Sales Growth = 100 * ((Net Sales This Year – Net Sales Last Year) / Net Sales Last Year)

So what have we done with the equation?  First of all we multiply by 100.  This is because this is usually expressed as a percentage.  So when we doubled sales earlier, we actually grew by 200%.

The second thing we have done to this equation is we have isolated the growth.  200% includes both the sales from this year and the sales from last year so it does not accurately represent the growth.  All we want is the growth part of the pie so we have to subtract 100% from the result in order to show just the growth part of the pie.

This is easy with the 200% because the result is 100% so we can say we had 100% growth is sales this year.

The second example is a little more tricky.  When you subtract 100% from 50%, you end up with -50%.

So what does this mean?  It simply means that there was a 50% decrease in sales this year.      A negative sign simply means that the sales this year are lower than the sales the previous year.

In the last post on this ratio, we will discuss the reason it is important and how to apply it to your business.  Remember…

…Your business THRIVES on a solid FOUNDATION!!!


Business Alchemy 101 Lesson 13–Sales Growth (Part Two)

As with all ratios, it is important to refer back to the previous lessons on ratios so that we can understand the Sales Growth ratio better (even though this one may be quite naturally understood).

Let’s take a look at the equation first so that we can answer our questions about it:

Sales Growth = Net Sales This Year / Net Sales Last Year

**Please note that these numbers are on the Profit and Loss Statement and are usually the very first line.  It is usually called Revenue.  Please note that Net Revenue does actually come after Gross Revenue on the statement if you had any Sales Discounts or Returns, otherwise, Net Revenue is the same as Gross Revenue.

So the first question requires us to identify the good guy in the equation.  I would say that the good guy is the Net Sales This Year.  We want the Net Sales This Year to win in this battle.

Question number two is regarding the point of view.  Since the bad guy is on bottom, we will be looking at how many of the good guys each bad guy has to eliminate in order for the bad guys to win.  So the higher the number the better growth we have had.

For an example, if we had $50 in sales last year and $100 in sales this year, the equation would be $100 / $50 and the answer would be two.  Each bad guy has to eliminate two good guys in order to win.  This is a very good result and actually means that our sales doubled.

If you were to reverse the numbers ($100 last year and $50 this year), then the result is only .5 now.  This means that each bad guy only has to wipe out one-half of a good guy to win and the bad guys win in this case.

We now have a good foundation established for understanding the basics of this ratio and this is definitely important because…

Your business THRIVES on a solid FOUNDATION!!!

 

Business Alchemy 101 Lesson 13–Sales Growth (Part One)

Sales Ratios are where Sheldon Gates begins his book and for good reason.  Nothing happens in a business until a sale is completed.  Until that point in time, you are merely spending money, not operating a business.

The first ratio that 101 Business Ratios introduces is the Sales Growth Ratio.

Growth may not always be a good thing for a company, but increasing sales will at some point be necessary in order to build a larger company. Continue reading