Is Growth Always a Good Thing?

posted on 06-07-2019

Growth equals success, right? Not necessarily. There are many companies that experience tremendous growth only to suffer poorly -- or even tank -- a short time later. Many of these fast-growing companies lose sight of the realization that long-term, profitable growth is a by-product of effective management and planning.

There are thousands of companies that drive themselves to ruin chasing market share and bragging rights. They're driven to grow the company at all costs. Unfortunately, this obsession with increasing sales at all costs leads to short-term growth and long-term losses. When a company, especially small a company, is growing fast it has to give equal attention to its operations and its costs if it wishes to succeed.

When a company is growing rapidly, it doesn't just mean grappling with the same problems on a larger scale. It means management—in some cases—must come up to speed in order to understand, adjust to, and deal with a whole new set of challenges. In essence, management will be dealing with a very different company.

If a company exceeds its sustainable-growth rate, it doesn't necessarily make a company a bad investment. Because of their growth opportunities, such companies can be among the highest-returning stocks. But just because a company is growing fast doesn't mean that it has no financial worries.

Sooner or later, a company will grow beyond the core management team's ability to micromanage it. The dot-com era was plagued with management teams that couldn't adapt to the complexities of rapid growth. But learning to let go is more difficult than it sounds. For example, there are CEOs who have founded companies that have done extremely well, but they've never had to share decision-making authority with someone else. They find it hard to do. Despite what their egos say, they're probably not capable of piloting the company to the next level and, as a result, should hand control over to someone who could.

If you decide to invest in a company that is growing faster than a sustainable rate, you need to consider what the company's options are to fund the excess growth and what the pros and cons of each strategy are. If you're in agreement with how the company's top management plans to manage its growth, fine. If not, you should walk away.

As a potential investor, you have to remember that a company might be able to rely on its cash on hand and other working capital to fund growth. But if cash flow cannot keep pace with the growth rate, a company often finds itself having to continually scramble to increase its debt-to-equity ratio, sell stock, liquidate assets, or take more drastic measures to finance growth.

This could create problems for shareholders. For example, when a company has a lot of growth opportunities, dilution from share issuances usually isn't much of a problem. As net income grows, earnings per share also grow—just not as fast. However, when growth is uneven or opportunities are lacking, raising equity capital may not be as attractive. Consequently, a drop-off in growth would leave earnings per share diluted with no compensatory increase in net income.

Following are a number of other pitfalls a fast growing company might encounter:

Cash is king: All fast growing companies will run into plenty of unforeseen costs. Even with good profits, there will almost certainly be times when a growing company will run tight on cash as expenditures outpace sales. Companies with inventory or receivables will run into this situation particularly fast.

Planning is paramount: While most companies may do a major overhaul of their projections and business plan once a year, with minor updates periodically, a fast growing company must update its plans, or at least its cash flow projections, several times during the year as significant deviations from what was projected occur in ongoing sales and/or expenditures. This constant updating will enable the company to make timely cuts in expenses and, if necessary, slow growth so that it doesn't run out of cash.

Profits off radar: When a company is expanding quickly, it is very easy to become excited about rapidly rising sales and lose track of profits. This is particularly true when a company reaches a stage where it has many managers.

Taxes increase: As a company becomes more profitable, its tax bill will likely increase at a higher rate than anticipated because it will move into a higher tax bracket.

Bigger facilities: A rapidly growing company may reach a stage where demand outpaces production capacity and, as a result, will need an increasing amount of space to house additional equipment or personnel. In such instances, the company often finds that its physical needs have outgrown its present facilities, but that its lease agreement or other unanticipated factors impede its ability to address the problem.

Customer service slips: Fast growing companies can become so fixated on winning the next customer that they forget about the ones who already paid -- the ones who will likely comment to friends about the company's level of service. Ironically, good customer service is one of the first things that tends to wane when companies are expanding at a fast pace. When this occurs, a company may not only have great difficulty retaining existing clients, but also may become less effective at securing new business.

It's not a bad thing for a company to want to grow quickly -- but not at the expense of quality and good planning. The flip side to growing fast is knowing when it's prudent to slow down. Companies that grow at an unsustainable level produce more harm than good. Business doesn't have to be like that. It's possible to grow at an affordable rate.

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