Determining sustainable growth.

At its quarterly partner's meeting, the managing partner of a surgical group celebrates the group's continuing growth. With great pride in his voice, he announces the business has grown over 35 percent in the past year.

However, when the chief financial officer comes forward to speak, she states the group must halt its growth rate or be prepared to forego bonuses or borrow money. The partners are surprised. The managing partner declares, "How is this possible? I thought growth was good for a business!"

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Many businesses, both small and large, have fallen into the trap of unbridled growth. We tend to think, "bigger is better," but is too much growth a bad thing? How do we know when to stop growing?

The answers lie in understanding the concept of sustainable growth. It takes money to grow a business. As business increases, so does the need for additional assets to support the growth in business. If growth exceeds the financial resources necessary to fund the increase in assets, cash flow may be impeded, resulting in unsustainable growth, and in some cases-eventual bankruptcy.

Simply stated, the rate of sustainable growth determines how much a business can grow without compromising its cash flow or having to borrow funds.

How do you determine the sustainable growth rate? If you look to a financial textbook for the answer, you will see the sustainable growth rate (SGR) is equal to the return on equity (ROE) multiplied by one minus the dividend payout rate (SGR = ROE X (1-dividend payout).

Since most medical practices are privately held, you can assume there is no dividend payout. The result is that the SGR equals the return on equity. Return on equity is a measure of operations and investing activity. It is determined by the return on assets (ROA) and the total asset turnover (ROE = ROA X total asset turnover).

A simpler way to break this down into components that make sense for a medical practice is to estimate the ROE and SGR using measures readily available to medical practices, namely profitability, variable assets and variable liabilities. The formula is expressed as:

SGR = [net profits %]/[[[Variable assets]/Billings] - [[variable liabilities]/Billings] - net profits]

The first step in estimating the sustainable growth rate by this method is to calculate the surgical practice's net profit after taxes as a percent of its billings. For example, if the billings are $20 million and the net profit $400,000, then net profit after taxes as a percent of billings is 0.02 or 2 percent. This assumes all profits are retained in the practice and are not distributed as bonuses.

The next step is to determine variable assets and variable liabilities as a percentage of billings. Variable assets are those that vary with the volume of billings.

For a medical practice, the accounts receivables would constitute the largest component of variable assets. If the surgical practice had an accounts receivable balance of $5 million on its billings of $20 million, then its variable assets as a percent of billings are 25 percent ($5million/$20 million).

Similarly, variable liabilities include accounts payable and any expenses accrued but not paid. They would not include any long-term notes. If the surgical practice's variable liabilities were $2 million on $20 million of billings, then its variable liabilities as a percent of billings are 10 percent ($2 million/$20 million).

Using these calculations, you can then estimate the sustainable growth rate for the surgical practice as follows:

SGR = [0.02/[0.25 - 0.1 - 0.02]] = [0.02/0.13] = 0.15 = 15%

As the chief financial officer correctly stated, if the group continues to grow at its current rate of 35 percent, it will exceed its sustainable growth rate of 15 percent. If unchecked, eventually the current rate of growth will outstrip the group's assets, forcing it to seek alternative funding.

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How important is understanding and calculating a sustainable growth rate for a business? It is important enough for Congress to mandate in the Balanced Budget Act of 1997 that Medicare not exceed its calculated sustainable growth rate in payments to physicians. Unchecked growth can be a disaster for any organization, whether public or private.

The lesson is that growth can be good, provided you understand the interrelationship between growth, the assets needed to support growth and the liabilities required to fund the assets. Determining the sustainable growth rate allows you to understand these relationships and to ultimately maintain a financially healthy and viable business.

By David Tarantino MD, MBA 

David P. Tarantino, MD, MBA, is the executive medical director of Shock Trauma Associates, P.A., a 50+ physician, multispecialty practice associated with the University of Maryland School of Medicine. In addition, he is the chief executive officer of The MD Consulting Group, LLC, a health care management consulting firm in Baltimore. He can be reached by phone at 410-328-2036 or by e-mail at [e-mail]