This chapter will demonstrate what happens to a company that mismanages its growth. When the external funds needed (EFN) are not planned for, a non-optional financing method may leave the firm susceptible to external shocks. After completing this chapter, you should be able to do the following:
• Recall the ratio of net sales to net worth and the ratio of fixed assets to net worth to help manage growth.
• Identify how growth can be mismanaged.
Evidence of Growth Mismanagement
There are two ratios that can help us determine when a company has mismanaged its growth. Both ratios have net worth (total equity) as their denominators. Mismanaged growth often occurs when fixed assets or sales grow proportionately faster than net worth:
• Fixed assets to net worth
• Net sales to net worth
Mismanaged growth will manifest itself in one or both of these two ratios. When these ratios rise materially, the firm may have grown faster than it could afford. A sharp increase in either of these two ratios will generally mean reduced liquidity and increased debt.
The fixed asset to net worth ratio measures the growth in fixed assets not financed with a proportionate increase in net worth. When this ratio grows, fixed assets are increasing faster than net worth.
Note: We are not considering the case in which this ratio grows because of declining net worth from losses.
As a result, debt will grow and liquidity will ...