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DEBT UTILIZATION AND A COMPANY'S SUSTAINABLE GROWTH Joseph J. Geiger University of Idaho Mario G. Reyes University of Idaho ABSTRACT In order to be successful in today's highly competitive environment, small business owners must understand the interrelationships between levels of debt, cost of borrowing, and the appropriate rate of growth. Banks and other traditional lending institutions shy away from detailed discussions of appropriate rates of growth with business owners because of (1) the complexity of the concept, and (2) the difficulty in presenting the information in a clear and easily understandable manner. This article describes and promotes the tool of sustainable growth, which any lender can use to assist a small business owner in determining the appropriate rate of growth for the firm's given costs and levels of debt. A numerical example is used to display tabular and graphical formats designed to facilitate communication and analysis between the lender and the business owner. The notion is introduced that any small business owner who understands and utilizes sustainable growth analysis can potentially develop the technique into sustainable competitive advantage. INTRODUCTION In order to be successful in today's highly competitive environment, small business owners must become cognizant of the interrelationships between levels of debt, cost of debt, and the appropriate rate of growth for their firm. As banks and other traditional lending institutions begin to stress financial services, owners should demand discussion and analysis from the lender on alternative courses of action (with respect to these three variables) to sustain company growth. In order to assist the small business owner in preparing for such a discussion, this paper briefly reviews current loan evaluation practice. The paper then describes and promotes a tool called sustainable growth analysis which any lender can use to assist the owner in determining the appropriate rate of growth for the firm given costs and levels of debt. CURRENT PRACTICE Loan processing for small businesses at the First Security Bank in Moscow, Idaho is representative of current practice. When Vice President John McCabe makes a loan judgment, it is a very

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considered decision. The bank's loan default rate is well below one percent, and his evaluation technique is both analytical and practical. He begins with a qualitative analysis of indicators of the five C's of credit, namely: Capacity, Capital, Collateral, Character, and Conditions. John then uses a commercial software package called the "FAST" system to assist in determining the liquidity, leverage, activity, and coverage information essential for assessing financial health and making credible financial forecasts. He becomes an expert on the quality of the customer's receivables, inventory, and the relationship between the firm's assets and the resulting income stream. Cash flows are scrutinized in great detail, especially the ability of the customer to weather a 'financial storm." The results are converted to a seven-point scoring system, and loans are awarded only for loans grading out in the top three positions. In short, John uses all the classic approaches which are refined quickly and efficiently with computer support and framed by careful attention to the personal character of the customer. Discussions with representatives from other banks revealed similar decision processes. Although existing software is amenable to the analysis of the relationship between debt utilization and company growth potential, most loan officers do not attempt to present a detailed explanation of debt-growth relationships because, as McCabe observes, "It is difficult for many small business owners to visualize." The lack of understanding of the relationship between debt utilization and growth potential can be easily overcome with the use of tabular and graphical techniques which make the impact of various debt level alternatives visual and understandable to both the lender and the small business owner. As will be demonstrated, the power of the visual approach is enhanced by the fact that the owner can determine the maximum level of growth at any level of debt. The business owner can relate his/her specific loan request and work intelligently with the lender in developing the most feasible sustainable growth financing package. THE SUSTAINABLE GROWTH MODEL Before a small business owner embarks on an aggressive growth strategy, the owner should examine the firm's sustainable growth rate. Sustainable growth is a company's rate of growth that is consistent with its key financial and operating ratios. Sustainable growth analysis is important because a small business whose actual sales growth exceeds its sustainable growth is an excess user of funds. Unsustainable growth, if not corrected, could exert tremendous stress on the company's financial and operating characteristics and may lead to financial distress.

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A simple formula to measure a firm's ability to grow is: SG = RR[EP + (EP-K)(D/E)] (1) This formula shows that a company's percentage rate of sustainable growth (SG) depends upon four factors, namely: (1) retention rate (RR), which is the percentage of earnings retained in the business; (2) after-tax earning power (EP), which is calculated as the ratio of after-tax net income to total net assets; (3) after-tax cost of borrowing (K); and (4) the level of debt utilization, which is calculated as the ratio of total interest-bearing debt to total owner's equity. Items 1, 2, and 4 can be determined from the financial information typically provided to the lender. Item 3 is derived from the lender's loan rate schedule (see example on the next page). The formula also shows the two sources of sustainable growth: (1) sustainable growth from retained earnings (RR times EP) and (2) sustainable growth from borrowing RR times (EP-K)D/E. Therefore, sustainable growth can be improved by increasing the retention rate, improving earning power, and/or increased debt utilization. However, increased debt utilization must be approached very carefully because of the possibility that increased borrowing may result in lower sustainable growth. We will show, using both tabular and graphical approaches, that sustainable growth increases with higher levels of financial leverage as long as the benefit from increased debt utilization exceeds the marginal cost of borrowing. Since the cost of borrowing is typically an increasing function of the amount of debt owed by the firm (that is, the higher the debt-to-equity ratio the higher will be the cost of borrowing), then there exists a debt-to-equity ratio which, if exceeded, would adversely impact the firm's sustainable growth because the marginal cost of borrowing at this debt level exceeds the marginal earning power of the firm. That particular debt-to-equity ratio maximizes the firm's sustainable growth declines because the benefit from financial leverage is now outweighed by the increase in the cost of borrowing. The following example will illustrate the impact of the debt utilization on sustainable growth. AN EXAMPLE Assume that Modern Tech Company earns an after-tax rates that the debt-to-equity ratio that corresponds after-tax 20 percent on its assets and retains 50 to the maximum sustainable growth is significantly percent of its after-tax net income. The company's lower than that found using the linear adjustment. marginal tax

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rate is 30 percent. Suppose Modern Tech's lender, East One Bank, adjusts its loan rate depending upon the level of debt utilization, more specifically by looking at Modern Tech's debt-to-equi ty ratio. All lending institutions believe that the more debt a firm has, the riskier a loan becomes. As an example, assume that the East One Bank us es the following linear approach to adjust its loan rate: K = 10% + 3% x (D/E) Note that each lender will have or can easily create an equivalent loan rate schedule. The typical loan rate schedule will show that the interest rate charged by lenders rises as the total amount of debt owed by the borrower increases. It could be linear or curvilinear, but it will reflect higher loan rates at higher levels of debt. This is illustrated graphically in Figure 1 and numerically in column 2 in Table 1 below, which also shows the relationships between debt utilization, loan rate, and sustainable growth. The sustainable growth rates presented in column 3 are calculated using the sustainable growth formula described in the text. Notice that, at low levels of debt-to-equity ratio, the sustainable growth increases as debt financing is increased. However, sustainable growth reaches a maximum point at 20.05%, which corresponds to a debt-to-equity ratio of 3 (i.e., 75% debt and 25% equity). Note carefully the decline in the sustainable growth at debt-to-equity ratios greater than 3; beyond 3 the marginal benefit from debt financing is outweighed by the increase in marginal borrowing cost. This phenomenon needs to be understood by the small business owner. Table 1 Financial Leverage, Cost of Borrowing, and Sustainable Growth Debt/Equity Ratio 0.50 0.75 1.00 1.25 1.50 1.75 2.00 2.25 2.50 Loan Rate 11.50% 12.25% 13.00% 13.75% 14.50% 15.25% 16.00% 16.75% 17.50% Sustainable Growth 12.99% 14.28% 15.45% 16.48% 17.39% 18.16% 18.80% 19.31% 19.69%

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2.75 3.00 3.25 3.50 3.75 4.00

18.25% 19.00% 19.75% 20.50% 21.25% 22.00%

19.93% 20.05% 20.03% 19.89% 19.61% 19.20%

The same conclusions are revealed from a graphical relationship between debt utilization, loan cost, and sustainable growth (see Figures 1 and 2). Figure 1 illustrates these relationships assuming the lender uses a linear adjustment when setting loan rates. Figure 2, on the other hand, provides a graphical illustration assuming the lender adjusts loan rate using a nonlinear methodology. Figure 2 demonstrates that the debt-to-equity r atio that corresponds to the maximum sustainable growth is significantly low er than that found using the linear adjustment. This is because the loan rate increases at an increasing rate as the level of debt financing increase s. Note, also, the dramatic decline in the sustainable growth rate in the case where the lender uses a nonlinear loan the more rate adjustment. From Figures 1 and 2 the feasible range of growth is easily observed, and this provides a basis for a high quality discussion between a loan officer and client. VALUE OF THE MODEL The model described in this paper should be useful in educating the small business owner in the relationship between debt levels, cost of borrowing, and appropriate (i.e., sustainable) levels of growth. When displayed in tabular or graphical form, the lender and the owner can engage in a sophisticated discussion of what should be the appropriate loan amount while understanding how rapidly the firm can grow without causing stress on the financial and operating characteristics of the business. Graphical presentations such as shown in Figures 1 and 2, when coupled with standard bank credit analysis, could enhance the client's understanding of the potential business financing options. The small business owner is thus placed in an excellent position to receive a customized loan which provides for responsible growth and acceptable risk. The technique, therefore, serves to enhance the ability of the small business owner to engage in prudent corporate finance while developing a lasting relationship with a valued lender. The result may very well constitute a sustainable competitive advantage for the owner over his/her competition.

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REFERENCES Higgins, R. C. (1977). How much growth can a firm afford? Financial Management, 26(3 Fall), 7-16. Higgins, R. C. (1981). Sustainable growth under inflation. Financial Management. Autumn. Gup, G. E. (1980). The financial consequences of corporate growth. The Journal of Finance, 35(5 December), 1257-1265. Kester, G. W. (1991). How much growth can borrowers sustain? The Journal of Commercial Bank Lending, June, 53-61. Lerner, E. & Carlton, W. (1966). A Theory of Financial Analysis. New York: Harcourt Brace and World, Inc. Rappaport, A. (1986). Creating Shareholder Value: The New Standard for Business Performance. New York: Free Press. Success comes too late for a small firm. Journal. Wall Street

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