Performance low? Blame accountants

Any company with solid double digit growth is a stock market darling. Yet growth rates in the mid-teens should be the norm.

Try a simple model of your own company. Take the first couple of years to finish the effects of any current initiatives. After this everything is just a formula.

Use modest assumptions. Let PBIT from existing operations keep pace with inflation at say 4%. Grow profits by a further modest 1% for continual improvement. For simplicity take interest costs at 7% on last year’s closing debt balance and take tax at 30% of profit after interest. Put in a dividend that is three times covered.

Assume you will always keep the balance sheet geared at 50% so that at the end of each year you invest to take debt up to that level. Also assume this investment earns an IRR of about 13%. This can be simplified by assuming your investment is at a perpetual seven times operating profit.

The spreadsheet for this fits onto one page of A4 quite easily (I can send you one if you email a request). And what it shows is fascinating.

First, the company quickly settles into stable growth of around 14% in every financial characteristic. Hence the norm in the mid-teens. But, more importantly, by varying the assumptions it shows which ones are crucial.

Naturally, if you increase the rate of continual improvement, you improve the rate of growth. And this is where a lot of managers, in my view, put far too much of their attention because this is where the glory seems to lie. Unless you inherited a badly run company, a continual rate of improvement much above 1% is hard to maintain unless innovation is a deep-seated culture.

Far more important, varying the IRR on investment causes big changes in the rate of growth. In my view this is where most companies fail. Wise investment can typically account for 90% of growth.

So why do companies not grow strongly – presumably because their investment is not wise. The average return is knocked back by disasters. Research is not properly carried out. Post-investment audit is not done or yields no lessons. Or whatever. This is simply procedural and so is the area where accountants can have the biggest impact. No flair is required except in identifying the projects.v Other assumptions are less critical. So the message to directors and analysts is that there are two things that matter for maintainable growth – corporate culture in relation to innovation and the rigour of practices relating to investment.

• Neil Chisman is a member of the Financial Reporting Council and the former finance director of Stakis.