To Main Proceedings Document
Proceedings of the 18" International System Dynamics Conference, Bergen, Norway, 6-10 August 2000
How to define a profitable and sustainable growth policy ina
changing market? A case study: a small publishing company
Enzo Bivona
Master Phil. in System Dynamics
University of Bergen - Norway
CUSA System Dynamics Group
P.zza A. Gentili, 12 - 90143 Palermo (Italy)
Tel. +39.0916254313 - Fax. +39.0916254532
http://www. unipa.it/~bianchi - E-mail: enzo.bivona@ libero .it
Keywords: business system, small business, sustainable growth model, system dynamics
Abstract
A tireless architect founded Grafill, a small book publishing company, at the end of the 80s. He
believed that in the real estate and construction sectors there is a lack of practical, reliable and
punctual sources of information. To cover such a gap, he launched a monthly review and, started to
publish a series of specific books and software to better support engineers, architects, and public
utilities in their tasks. During the last two years, both the number of books published and software
released, and their relative prices have been sharply increased. Such business strategy contributed
to strongly increase company sales revenues, but it didn’t generate a proportional growth in
company bank balance. Such period has been also characterised by investments in E-commerce and
related customer services, which shows a growing contribution in terms of company sales. On the
basis of such results, the entrepreneur believes that this is the right way to pursue Grafill’s growth.
In particular, for the next two years, he foresees to reinforce the number of product to be launched
and E-commerce activities. Such growth policy, according to owner’s vision, will enhance virtuous
circles that will allow the firm to increase direct sales and related margin, so that to finance further
business development. A system dynamics modelling approach has been adopted to better
understand business areas interconnections, to assess sustainable strategies and to share learning
among the entrepreneur and his direct collaborators.
The firm as a dynamic system: implication for business management policies
The continuous changes in technological innovation and its fast development have strongly
contributed to increase small businesses’ complexity and difficulties in coping with new market
dynamics. The relevance of such aspects is obvious in all firms, but it assumes a critical role in
small firms. Such companies are very often characterised by limited financial and management
resources and, as a consequence, a reactive rather than proactive business growth strategy may
easily lead to business failure. A case study has been analysed - by the light of the sustainable
growth model combined with the system dynamics perspective - to provide insights and
contributions in helping both small and medium enterprises (SMEs) and academic researchers in
better understanding and designing SMEs’ sustainable growth strategies.
A prerequisite to define a profitable and sustainable growth policy in a changing market is to
understand the interrelationships among company sub-systems and between the firm and its relevant
environment. For this reason, it has been adopted a business framework analysis to depict the firm
as an interrelationship of variables that continuously interact with the environment. In fact, by
adopting a system perspective, a firm can be seen as a dynamic interrelationship of different
elements or variables aimed to pursue company goals. In particular, a company can be represented
through a combination of three main elements: 1) a structure in terms of resources (e.g., capital,
personnel, organisation) that represents the backbone of the company; 2) management activities,
that can be distinguished in operational and strategic. Operational activities are usually short term
oriented and focused on efficient utilisation of available company resources (e.g., equipment,
human resource). Strategic management activities are long term-oriented decisions, aimed to define
company targets and related policies and organisational structure. Indeed, in SMEs such distinction
becomes very hard because they are often characterised by unstructured management organisation
(e.g., not well-defined personnel roles) and what can be defined as ‘operational’ in the short term
could become ‘strategic’ in the meantime (Bianchi and Bivona, 2000). For instance, operational
management activities through an efficient utilisation of company resources based on costs
reduction, a standard customer's services (i.e., based on low lead time) can also generate strategic
outcomes that may allow the firm to easily catch up business goals. And, finally, 3) management
results represent the third aspect of the firm. Management activities are often measured by using
indicators to take into account financial (e.g., return on investment, retum on equity, debts/equity
ratio), competitive (e.g., market shares, number of customers) and social (e.g., personnel,
shareholders and financial institution satisfaction) results and to capture business growth. In
particular, business growth can be analysed according two dimensions: a ‘quantitative growth’
characterised by an increasing in company tumover, human resources, etc., and a ‘qualitative
growth’ in terms of human resources skills, innovation, business flexibility in adapting to
environmental changes. Such distinction is helpful to identify apparent (i.e., only quantitative) and
short term from real and sustainable medium/long term business growth.
STRATEGIC
MANAGEMENT
THE
ENVIRON- OPERATIONAL
MENT MANAGEMENT
STRUCTURE
‘wy | RESULTS
THE FIRM
Figure 1- The Business System
(Source: Coda, 1989)
As we can see from the above figure, efficient operational management activities and effective
strategic management activities could modify the business structure of the firm, on the basis of the
environment’s changes, leading to firm growth. Such modified business structure could foster
virtuous circles that may allow the firm to reach/maintain both a sustainable competitive advantage
and financial business equilibrium. On the contrary, inconsistent management activities could
generate eroding processes of company resources leading to business crisis. In fact, if business
growth is generated by chance and is not well supported by coherent strategic and operational
management activities, a potential business failure may eventually result.
The above framework is an important first step to define the main forces that have to be taken into
consideration to sketch a growth policy for a firm. However, to focus on the relevant aspects that
could influence business growth, it is necessary to follow a selective approach. Often, one of the
main problems for management is the following: given several external forces, how can the firm
monitor all environmental conditions? In defining an effective environmental framework of
analysis, Grant (1995) suggests to distinguish vital from merely important forces. In particular, he
suggests that a firm should focus on its network of business relationships that is formed by
competitors, suppliers, and customers. He also states that this is not to say that general
environmental factors such as economic, social or political trends are unimportant, but they may be
critical determinants of the threats and opportunities a company could cope with in the near future.
Indeed, in a changing and unpredictable business environment company strategies can not neglect
to take into account macro-environmental forces such as technological, social, national/intemational
developments that in today’s economy are strongly affecting firm dynamics (i.e., “the new
economy”). Understanding business internal interconnections and the relationships between the
firm and the environment in which it operates will help us in supporting how to define a business
growth strategy and to seek for relevant forces that could play a crucial role in such analysis. In
defining a business growth policy the strategic and accounting literature suggest to take into account
the sustainable growth model. In particular, this paper aims to combine such an approach with the
system dynamics perspective and apply it to a case study.
Company sustainability
According to the business management literature, a firm in pursuing business goals has to take into
account either intemal (e.g., owners, employees) and external (e.g., banks) business key-actors
expectations and it has to maintain an economic and financial equilibrium. In particular, a firm to
reach a sustainable pattern should be able to dynamically take into account all previous remarks.
For example, business success based on aggressive commercial policies that generates in the short-
medium term financial shortages could cause banks’ complains and, as a consequence, a reduction
in available bank credit leading to a business liquidity crisis and subsequently a company failure.
From the above statements it is possible to observe that a company to sustain or reach a given
market position has to be able to:
a) promptly adapt its business structure to new market conditions (Durability);
b) self-finance its business activities in pursuing business goals (Autonomy), and
c) achieve a financial equilibrium (Profitability).
7 /
DURABILITY =a AUTO
MY
| PROFITABILITY ,
Figure 2 - Business interrelationship between Durability, Autonomy and Profitability
(Source: adapted from Airoldi, Brunetti, Coda, 1989)
The structure reported in figure 2 allows one to capture the basic factors that can lead to virtuous
business cycle. Nevertheless, to define a sustainable growth policy all previous aspects have to be
combined with a business growth rate suitable with the competitive arena dynamics. Such business
growth has also to be in consonance with a balanced financial structure according to the equity
owners’ strategies and external key-actors’ expectations (e.g., banks and financial institutions). In
other words, a sustainable growth strategy has to allow the firm to achieve a satisfactory business
growth, profitability and liquidity ratio taking also into account environmental dynamics and
owners’ requests.
Traditionally, the relationships between growth, profitability and assets changes have been analysed
through the sustainable growth model (Zakon, 1966). Such a model is one of the comnerstones in the
financial literature, to which both researchers and practitioners have been referring over the last
decades. This model suggests that growth could be internally sustainable, if the net assets growth
rate is not higher than the retained earnings growth rate. A first version of the sustainable growth
model, that is the sustainable ‘internal’ growth model, is only based on the current internal flow of
funds (Current Income + Depreciation). Such statement is due to the following assumptions: (1)
capital investments are considered as a scarce resource, both in terms of equity investments and
debts, and (2) the management desire to maintain the actual financial structure. In other words,
market difficulties to find out financial sources, on a side, and the financial structure desired by the
management, on the other, force the firm to finance business growth through current internal flow
of funds.
According to such model, a company can grow - without external capital investments and changes
in the financial structure - according to its ability to generate internal flow of funds. In particular, if
company internal sustainable growth rate is expressed as ‘Delta equity percentage’ and the current
internal flow of funds as Retained earnings percentage divided by equity, company internal
sustainable growth rate (g) can be seen as follows:
i Retained earnings
{1] g = Equity
If we observe that ‘Retained earnings’ is equal to ‘Net income - Dividends’, through some
mathematical operations, the previous formula can be expressed as follows:
[2] g?=ROE (1-d)
' g =company internal sustainable growth rate (% changes in initial equity); Retained eamings/Equity = current internal
flow of funds %
? Some of the most common used measures to evaluate business profitability are: the ‘Retum of Investment’ ratio
(ROI), which shows the ability of the operational activities to generate income from a given level of investment, and the
5
In other words, if a company foresees to reach a ROE = 20% and to distribute the 30% of the Net
income (d = 0,3), it can self-finance an assets growth equal to 14% (20%* 0,7).
In reality such model embodies some limits related to the ability of the firm to find out new
financial sources and owners’ willingness to accept changes in the business financial structure. Such
limitations can easily be overcome by reviewing the previous formula.
Retained A New Equity
AA. _ _ Eamings Investments», Debtswi- Equity.
43S =
[Sal G Ay Equity. Equity. Ke
As we can observe from the above formula [3a], the business sustainable growth rate is
characterised by three components:
1. Retained earnings/Equity. = changes in assets % due to changes in current internal flow of
funds;
2. ANew Equity Investments./Equity.= changes in assets % due to new equity investments;
3. (Debts...- Equity...)/Aw = changes in assets % due to changes in the debts/equity ratio.
A raise in all these three factors contributes to increase the business sustainable growth rate. In fact,
an increase in retained earnings, equity investments and in the amount of debts, by generating
financial resources, encourages company growth. In particular, it is worth remarking that high
dividend if, on a side, satisfies business-owners’ requirements and expectations, on the other, drains
financial resources that could fuel further business growth. As a consequence a company that wants
both to maintain a specific growth rate and to reward equity investments according to business-
owners’ expectations has to increase business operating profitability and/or its debts to equity ratio.
Nevertheless, an increase in debts could provide new financial resources and, hence, generate
further growth if the cost of borrowing is lower than the retum on net assets. Such statement is
directly related to the correct use of financial leverage. In fact, in such a case an increase in net
profitability generates new financial resources leading to further business growth. An example will
help the reader to better understand the above formula [3a].
‘Return on Equity’ ratio (ROE), which is the relation between the net income generated by all business activities and
the amount of the equity invested.
ROE = Net Income/Equity
d = Dividends paid % (Dividends Paid/Net Income).
3 g* = sustainable growth rate
A(t) = Ending total assets from the previous period
Equity(t) = Equity at the beginning of the budget period
Equity(t+1) = Equity at the end of the budget period
AA(t)= Changes in Assets.
At the beginning of the budget period, a company appears as follows: Assets (A.) = 1000, Equity.=
500 and Debts. = 500. For the budget period, the company foresees:
ROE = 20% (Net Income/A ssets.);
d=0,4;
New Equity Investments . = 100;
Debts/Equity ratio target (Debts... /Equity..) = 1,5.
On the basis of such figures, at the end of the budget period Equity could reach 660 (initial equity,
500, plus net income retained, 60, plus new equity investments, 100) and the amount of the debts
could be equal to 990 (Debts... Equity... = 1,5 and, hence, Debts = 660*1,5=990).
100*(1-0,4) 100 990-660
k=
[3b] g 500 ~*~ 500. *~ 1000
Hence,
Bc] gk = 0,12 + 020 + 033 =65%
The above formula shows that the:
company can internally finance business growth equal to 12% (100*(1-0.4)/500);
new equity investments contribute to increase business growth rate for 20%, and
changes in debts provide an increase of the 33% of the company sustainable growth rate.
In conclusion, such figure shows that the assets at the end of the budget period could grow up to
1650 (+ 65%) in compliance with the business financial structure desired by the management.
The above formula [3a] provides a simplified schema to figure out the relationships between the
variables embodied in the business system. Understanding such links allows the management to
improve business decisions aimed to achieve the desired business growth rate under a pre-defined
profitability and debts to equity conditions. Such discussion can be reviewed on the basis of the
diagram portrayed in figure 3. The causal and effects diagram shows how the three main business
variables/decisions (e.g., retained earnings, new equity investments and the amount of debts) could
foster or slow down company growth. In particular, an increase in retained earnings could generates
internal flow of funds, enhances further business growth and gives rise to operating (ROI) and net
(ROE) investment retums. Such business growth, by increasing ROE, will decrease the debts/equity
ratio and, as a consequence, the interest cost. Then, a reduction in interest cost will produce a
further increase in ROE. Such interrelationships will generate, in the short time period, a virtuous
circle that can easily feed business growth. But as equity will increase ROE will fall down.
Afterwards, low returns could arouse owner’ s complains leading to a reduction in retained earnings.
Consequently, the entrepreneur has to find out new ways to generate further growth. Furthermore,
in case the debts/equity ratio is reaching high value, banks and/or suppliers could start to reduce
company available credits, so that it will be necessary to restore the level of debts by increasing
equity investments. But, if on a side such policy could re-establish the debts/equity ratio to a
suitable level, on the other it will fall down ‘again’ net business returns. Such side effect represents
a strong limit to business growth. In fact, low margin will produce equity owner’s complains
leading to an increase in dividends, a reduction in financial funds and as result business growth will
Retained
earnings
slow down.
Interest
a" Costs
«
Internal Flow RO!
of Funds
} Tas. | Personal
"ee J
+
“~ Thoms
Growth gq +
Figure 3 - The sustainable business growth model
Figure 3 also embodied a new variable: ‘Personal Assets’. This variable has been added because it
captures a peculiar aspect in SMEs’ context. In such firms, family asset is often the main means to
fulfil business growth. In fact, when financial institutions and/or business suppliers are not willing
to increase firm credits and, hence, to finance further company growth, a firm can only try to win
their reluctance by bringing new equity investments. In the following section the sustainable growth
model has been applied a case study.
A small publishing company
At the end of the 80s, a tireless architect founded Grafill, a small book publishing company. He
believed that in the real estate and construction sectors there is a lack of practical, reliable and
punctual sources of information. To cover such a gap, he launched a monthly review and, started to
publish a series of specific books and software to better support engineers, architects, and public
utilities in their tasks. During the first 6" years Grafill faced a growing trend in the number of
review subscribers and clients that never seemed to end up. Both sales revenues and bank accounts
grew up, and a new employer was hired. But, such positive trend stopped at the end of the 7" years.
As consequence, the owner starts to ask himself the following questions: how can be explained such
a raise and fall in number of subscribers? What could cause such a decreasing pattern? How can a
sustainable growth policy be designed and achieved? Does company growth requires further equity
investments?
The owner-entrepreneur believed that an increase in the number of products launched will strongly
contribute to increase Grafill’s customers, sales revenues and bank balance. As a consequence,
during the last two years, Grafill operational activities have been mainly devoted to slightly increase
the number of books and software launched and to regularly publish its monthly magazine.
Figure 4 - Owner-entrepreneur’s growth strategy
In addition, such period has been also characterised by a resources investment in E-commerce and
related customer services, which shows a growing contribution, even if marginal, in terms of
company sales,
160.000
140,000
120.000
100,000
20,000
60.000
[== Postve bank balance
[mae Negative bank balance
40.000 [Total sales revenues
20000 —Y
+—i
= =
PQuoter-2"Quater —3*Quater—a*Quater—1* Quater ter 3*Quater 4° Quater
20.000
40,000 Sy
60.000
Figure 5 - Grafill’s Total Sales revenues and Bank balance
The business strategy implemented by the owner - as expected - contributed to increase company
sales revenues, but it didn’t generate a proportional growth in company bank balance (see also
appendix 1).
As we can observe in figure 5 Grafill’s sale revenues grow up, while bank balance shows a
decreasing pattern. Even though such strategy requires an increase in financial debts, it allows the
company to reach an average operating profitability (ROI) equal to 26% and an average net
profitability equal to 17%.
On the basis of such results, the entrepreneur believes that this is the right way to pursue Grafill’s
growth. In particular, for the next two years, he foresees to reinforce this strategy (that is mainly
based on an increase in Grafill’s portfolio products, see figure 4) by launching 3 products monthly.
Furthermore, dues to market demand changes and Intemet development, the entrepreneur is also
oriented to invest on customer’s E-commerce related services. For this reason, he prognosticates to
increase E-commerce investments and to hire a new employer. Such decision aims to establish a
direct link with the final customer, to shrink the distribution channel and, hence, increase company
sales margin. The owner-entrepreneur believes that an increase in customers’ related services tied to
the “New Economy” (i.e., on line commerce) will not only increase company customers and sales,
but will also improve company image. Such growth policy, according to owner's vision, will
10
enhance virtuous circles (i.e., based on word of mouth) that will allow the firm to increase direct
sales and related margin, so that to finance further business development.
This strategy has been ‘simulated’ through a spreadsheet-based financial model (A summary of
Grafill Income and financial statement has been reported in table 1).
TOV 2° Year
1999 (FORECAST) | (FORECAST)
INCOME STATEMENT
Indirect Sales Revenues 494.309 667.680| 908.219|
E-commerce Sales Revenues 54.923 225.581 472.713
|- Discounts 247.155 333.840 454.110
NET SALES 302.078) 559.421 926.822
OPERATING INCOME 102.685 218.269) 472.136)
NET INCOME 48.227 100.274) 225.843
FINANCIAL STATEMENT
ASSETS
Equipment (net of depreciation) 5.000) 2.500) 0|
Inventories 364.440 545.788| 629.602
Accounts receivables 56.357 68.505 86.421
Positive bank balance () 0 iY
TOTAL ASSETS 425.797 616.793 716.023
LIABILITIES
Equity 292.867 363.059) 521.149)
Short terms debts 54.667 58.000 61.333
Negative bank balance 78.263 195.735 133.541
TOTAL LIABILITIES & EQUITY 425.797 616.793 716.023
ROI 24,12% 35,39% 65,94%
ROE 16,47%| 27,62% 43,34%
DEBTS/EQUITY RATIO 0,45 0,70 0,37
Table 1 - Grafill’s results budget (2000 - 2001)
Quarterly company results 1998 - 2001
Figure 6 - Grafill’s quarterly results (1998 - 2001)
11
[arr
lmoe
oebstequty aio
average Debs quity ratio
eee 1998 1990 2.000 2001
Figure 7 - Grafill’s quarterly results (1998 - 2001)
Figures 7 and 8 reported above show that entrepreneur's growth strategy allows the firm to increase
business operating and net profitability. In particular, such a profitability growth is mainly due to a
sharply increase in direct sales (E-commerce) that lets Grafill to pursue an increase in sales
revenues margin. Another effect of such policy is related to business liquidity. As we can observe
from figure 6 company bank balance at end of the first year budget (31-12-2000) shows a
decreasing pattern (-195.735), even if it starts to increase during the second year budget (-133.541).
It is worth remarking that, at the beginning of the 2000, Grafill’s bank balance was equal to -
78.263. In particular, figure 7 portrays Grafill’s profitability and debts/equity ratio dynamics.
During 2000 the debts to equity ratio shows a strong increase, but during the next year it goes
slowly down. On the basis of such results, the owner entrepreneur is asking if this is a sustainable
growth strategy. To answer such a question it has been applied the sustainable growth model.
According to the Grafill’s budget results (2000-2001), it is possible to detect the following
information:
average ROE = 35%; d = 0.3; New Equity Investments .. = 0, and the desired debts to equity
ratio (Debts.../Equity...) =1,5.
On the basis of such information the sustainable business growth rate would be:
g =25% +0+43% =68%
In other words, such estimation tells us that the total assets during the budget period can grow up
from 425.797 to 715.339 (+68%) without changing the financial equilibrium defined by the owner-
entrepreneur. In conclusion, according to the business sustainable growth model and owner's
requirements (e.g., dividends, new equity investments debts/equity ratio) the suggested Grafill’s
12
growth strategy which requires an increase in capital invested equal to 68% [716.023-425.797)/
425.797], can be defined as “sustainable”.
During last 30 years, the sustainable growth model has been mainly appreciated both for its
simplicity and its useful suggestions during the budgeting process. In particular, it seems to strongly
support managers to evaluate ex-ante the sustainability of business growth policies, according to a
given financial structure and owner’s requirement. Such model also looks useful to investigate ex-
post analysis. In fact, entrepreneurs could evaluate periodically (i.e., quarterly) business reports by
detecting possible variances, analysing their causes and implementing new decisions to achieve the
desired business results.
However, although it is simple and relatively ready-to-use, it appears more useful for an ex-post
analysis, rather than to support entrepreneurs in setting their growth policies for the future. Among
its limits, it is possible to observe that it does not make explicit causal determinants of profitability
and business liquidity; it does not take into consideration the ‘time’ variable (i.e. delays between
causes and effects) and the dynamic feedback relationships between growth, profitability and
liquidity. As a matter of fact, an analysis aimed to design a sustainable business growth policy can
not discard to analyse the ‘dynamic’ interrelationships between business growth and company
health. In order to overcame such weakness it has been built a system dynamics model.
The system dynamics methodology has been applied to take into account the dynamic
interrelationship inside the firm and between the firm and the environment in which it operates. In
particular, the simulation model ‘dynamically’ depicts the interrelationships between profitability,
liquidity and business growth and the relationships between company perceived solidity and
external key actors’ expectations/consensus. For instance, available bank credit will increase as
company tumover and equity will grow up, and vice-versa. In fact, the system dynamics
methodology allows one not only to make explicit and dynamic the implicit, linear and static
feedback relationships suggested by the owner-entrepreneur (i.e., see figure 4), but also to explore
the existing relation between business results and external consensus (i.e., banks and suppliers
requirements). The feedback relationships suggested by owner have been made explicit and
embodied in the system dynamics simulation model (see figure 8).
13
wq
’ > cogil OT
+
Figure 8 - Main (positive) feedback loops suggested by the owner-entrepreneur
embodied in the System Dynamics simulation model
In particular, figure 8 captures the positive relationships between the following variables: ‘number
of company products launched’ and company growth. In fact, an increase in company’s products
launched could generate a growth in company sales, and by generating new financial resources
could feed further business growth. At the same time, a raise in returm on assets could boost
personal assets that through an increase in business solidity perceived by external actors generates a
growth in available bank credit. As a consequence, an increase in financial resources could feed
further rise in the number of products launched. On the basis of such relationships, the growth
strategy suggested by the owner-entrepreneur has been simulated through a system dynamics
simulation model. It is worth remarking that the simulation period has been divided in 192 weeks (4
years) and, while the first two years are referred to 1998-1999 the next two years are referred to the
budget period (2000-2001).
As we can see from figure 9, company customers increase as the number of products launched
growth up. Such a growth also generates an increase in customers’ orders and company sales
revenues. In particular, due to entrepreneur’s decision to invest in E-commerce activities (see figure
10), for instance, web site improvement, security payment, etc., it is possible to observe a strong
increase in direct sales revenues.
14
TOTAL PRODUCTS CUSTOMERS
10
1.030.
65: g
2
£ 9 1.020.
Z 60.
5 &
55. © 1.010-
50y 1.000+
0 50 100 150 0 48 96 144 192
CUSTOMERS' ORDERS SALES REVENUES
15.000 T
40
p
© 35 Ss net
2 3 10.000 1 Indirect_Sales_Revenues
© 30 a —7Ecommerce Sales Revenues
© 5 5.000- y
——,
2004 of}
0 48 96 14a 192 0 48 96 144 192
Figure 9 - Grafill’s business variables dynamics taken form the
System Dynamics simulation model
E-COMMERCE INVESTMENT
2.0004
= 1.5004
g
= 1.000
ai
a
0 + t +t 1
0 48 96 144 192
Figure 10 - Grafill’s E-commerce investments
The reader will already noted that the above figures portray Grafill’s variables dynamic until week
157. Such factor is mainly due to an unexpected phenomenon that by draining financial resources
has generated a financial shortage leading to a business crisis.
The owner-entrepreneur’s growth strategy based on an increase in products launched and E-
commerce investments allows the company to boost sales revenues and to achieve the expected
level of profitability foreseen in the budget plan. But, as the amount of books and software released
increase, the inventory grows up as well as the accounts receivable. Such an increase generates a
higher level of financial resources needed to feed business growth. In fact, as Grafill’s net working
15
capital * increases bank balance goes down until it reaches the available bank credit (that is the
amount of financial resources provided by financial institutions) leading to a business failure. In
other words, even though the business growth strategy suggested is profitable (net income shows
positive values and an increasing behaviour), the flow of financial resources generated by such
strategy does not allow Grafill to reach and maintain a sustainable growth pattern. Such
phenomenon can be observed in figure 11 (Grafill simulated results have been also reported in table
2).
SALES REVENUES BANK BALANCE (1) - AVAILABLE BANK
800.00 BALANCE (2)
~ 600.000.
S _
8 3 100.00 -
= 400.00 g
200.000. “4 -200.00 ae
-300.00 124
0 48 96 144 192 0 48 96 144 192
NET INCOME NET WORKING CAPITAL
600.00
1.60 500.00
8 1.401 3 400.00
~ 120 ~ 300.00
ai ui
1.00 200.00
80 100.00
0 48 96 144 192 6 Fe 36 Ta 183
Figure 11 - Grafill’s financial results
Why does the system dynamics simulation model portray different results from those generated by
the spreadsheet model based on the sustainable growth model?
First of all, besides the sustainable growth model limitations stated in the previous pages it is worth
remarking that such model being a ‘synthetic’ indicator does not capture the main business
variables dynamics. In particular, it does not make explicit the dynamic of the financial resources
needed during the budget period (Brunetti, 1983). Thus, even if the foreseen profitability and equity
changes suggested by a growth strategy, which has been identified as ‘sustainable’, could be
matched ‘in reality’, it may happen that during the budget period a company could face with
liquidity shortages. Such phenomenon, by reducing company bank balance could generate a vicious
circle (negative bank balance = higher interest costs > higher negative bank balance) that could
“ Net working capital = Account receivables + Inventory - Account Payables.
16
lead to business failure. Moreover, the existing delays between decisions and effects also contribute
to generate behaviours that could look different form those foreseen in the budget plan. Introducing
a feedback and dynamic perspective during the drawing up of a company budget allows participants
to evaluate the sustainability of a business growth strategy not only by taking into account business
variables values at beginning and at end of the budget plan, but also, and in particular, their
dynamics during such period. This analysis also provides to entrepreneur and his collaborators an
explicit framework to be discussed and modified according to their own vision and external key
actors’ requirements. Furthermore, the system dynamics simulation model trough a user-friendly
interface and a spreadsheet data-interchange ° allows users to test ex-ante in a ‘safe’ environment
their decisions and related ‘implicit’ expectations. Understanding causal relationships underlying
business results it is possible to feed a double loop learning (Davidsen 1996; Sterman, 1994) which
could support decision makers in detecting inconsistencies in their mindsets and, hence, improving
the decision making process. Therefore, to design a sustainable growth strategy decision maker
needed to take into account the dynamic interrelationships between business growth and its drivers
in compliance with a balanced business financial structure, a satisfactory business profitability and
liquidity, which may allow the firm to gain both internal and external key actors’ consensus
(Winch, 1993).
In conclusion, this paper aims to highlight some of the limits of the sustainable growth model and to
suggest a way to overcome such partial analysis. It has been demonstrated that a feedback approach
could useful support small business entrepreneurs in assessing their business growth strategies, in
compliance with a desired profitability level, a desired balance financial structure and extemal key
actors’ requirements.
5 The system dynamics model allows users to make their decisions and check business results both in the System
Dynamics package and in a spreadsheet model.
17
\Grafill Balance sheet
2000 (SIMULATED)
2001 (SIMULATED)
1° Quater_[ 2° Quater [3° Quater [4° Quater [TOTAL 1° Quater_[ 2° Quater_[ 3° Quater [4° Quater [7 TOTAL
INCOME STATEMENT
Indirect Sales Revenues 143.382) 156.722) 171.890} 186.012| 658.006) 196.744| 0} 0 O| 196.744)
E-commerce Sales Revenues 23.958 30.260} 38.688} 48.106] 141.012) 57.577| oO} 0 fo) 57.577
Discounts. 71.691) 78.361) 85.945] 93.006} 329.003) 98.372 fo) fe] fo) 98.372
INET SALES 95.649, 108.621) 124.633) 141112) 470.015) 155.948) 0 oO} oO 155.948)
Changes in Product Inventory 56.976] 52.972| 48.286] 43.563] 201.796] 39.434| 0} 0 fo) 39.434|
IPRODUCTION VALUE 152.626] 161.593| 172.918 184.674, 671812) 195.383) 0 0 Oo 195.383)
Batch related costs 90.000} 90.000} 90.000} 90.000} 360.000) 90.000] 0} 0 fo) 90.000)
E-Commerce costs 9.000} 9.000} 9.000} 9.000} 36.000} 9.000} 0} fe] fo) 9.000}
\WALUE ADDED 53.626, 62.593) 73.918) 85.674) 275.812) 96.383) a oO oO 96.383)
Editorial staff 18.526] 19.145) 19.371) 19.453 76.496] 19.483 0} 0 fo) 19.483)
|GROSS OPERATING MARGIN 35.099) 43.443) 54.548) 66.221) 199.316) 76.900) LJ 0 oO 76.900)
(General & Administrative costs 10.727] 11.080) 11.486] 11.798} 45.091) 11.956) 0} 0 fo) 11.956]
Depreciation 353} 334! 315| 297 1.299) 281 0} 0 fe) 281
\OPERATING INCOME 30.768) 38.784) 49.497) 60.876} 179.925) 71413) 0 0 oO 71413)
Interest costs 5.838} 7.022) 8.310) 9.437 30.606} 10.305 0} 0 fe) 10.305
INET INCOME BEFORE TAX 24.931) 31.762) 41.187) 51439) 149.319) 61.108) a 0 oO 61.108)
|Taxes 12.465) 15.881) 20.594! 25.719] 74.659) 30.554] oO} 0 fo) 30.554]
INET INCOME 12.465) 15.881) 20.594) 25.719) 74.659) 30.554) oO oO) oO 30.554)
FINANCIAL STATEMENT 31-03-00 | 30-06-00 | 30-09-00 | 31-12-00 31-03-01 | 30-06-01 | 30-09-01 | 31-12-01
ASSETS
Equipment (net of depreciation) 5.948) 5.614] 5.299} 5.002 4.722) 0} 0 ie)
Inventories. 406.212} 459.184) 507.470} 551032 590.466] 0} 0 i9)
\Accounts receivable 70.554) 75.909} 82.683 89.597 95.370] 0} 0 ie)
Positive bank balance fe) 0} fe) a 0} 0} 0 ie)
TOTAL ASSETS 482.714) 540.707) 595.452) 645.631 690.558) a oO Q
LIABILITIES
Equity 218.545} 229.661) 244.077; 262.081 283.468] 0} fe] te)
Long terms debts fe) O| fe) a oO} oO} 0 QO
Short terms debts 80.212 88.911 92.521] 94.230 95.121) 0} 0 ie)
Negative bank balance 171.492) 206.254) 238.260) 263.601 281.414! fo) fe] ie)
Deferred income taxes 12.465) 15.881) 20.594] 25.719 30.554] O} 0 ie)
TOTAL LIABILITIES & EQUITY 482.714, 540.707; 595.452) 645.631 690.558) 0 oO q
Table 2 - Grafill simulated results 2000 - 2001
18
Appendix 1 - Grafill Balance sheet 98 - 99 s
|GRAFILL BALANCE SHEET. 1998 1999
1° Quater_| 2° Quater | 3° Quater | 4° Quater || TOTAL 1° Quater | 2° Quater | 3°Quater | 4°Quater | TOTAL
INCOME STATEMENT
Indirect Sales Revenues 108.000} 103.950} 107.055} 109.850] 428.855) 112.365) 114.628} 116.665) 118.499) 462.157
E-commerce Sales Revenues 12.000} 11.550] 11.895) 12.206} 47.651) 12.485) 12.736] 12.963 13.167| 51.351)
Discounts 54.000} 51.975] 53.528] 54.925| 214.427 56.182 57.314| 58.333} 59.249] 231.078)
NET SALES 66.000) 63.525) 65.423) 67.130} 262.078 68.667) 70.051) 71.295) 72.416 282.429
Changes in Product Inventory 4.200} 4.830 25.347 24.912 59.289} 24.521 24.169 23.852 23.567 96.109}
PRODUCTION VALUE 70.200} 68.355] 90.770) 92.043| 321.367] 93.188) 94.219) 95.148) 95.983, 378.533)
Purchase 21.000} 21.000 42.000} 42.000} 126.000) 42.000} 42.000} 42.000} 42.000} 168.000)
E-Commerce costs 6.000} 6.000} 6.000} 6.000} 24.000} 6.000} 6.000} 6.000} 6.000} 24.000}
\VALUE ADDED 43.200) 41.355) 42.770, 44.043) 171.367) 45.188) 46.219) 47.148) 47.983} 186.538)
Editorial staff 18.000} 18.000} 18.000} 18.000} 72.000} 18.000} 18.000} 18.000} 18.000} 72.000}
IGROSS OPERATING MARGIN 25.200) 23.355) 24.770) 26.043) 99.367] 27.188) 28.219) 29.148) 29.983, 114.538)
|General & Administrative costs 6.000} 6.000} 6.000} 6.000} 24.000} 6.000} 6.000} 6.000} 6.000} 24.000}
Depreciation 625] 625 625] 625 2.500] 625] 625 625 625) 2.500)
OPERATING INCOME 18.575) 16.730) 18.145) 19.418} 72.867) 20.563) 21.594) 22.523) 23.358} 88.038)
Interest costs ie) 0 ie) oO} O} i) 0} 430) 941) 1.371)
NET INCOME BEFORE TAX 18.575) 16.730) 18.145) 19.418} 72.867) 20.563) 21.594) 22.092) 22.417| 86.667
| Taxes 9.288} 8.365 9.072! 9.709} 36.434] 10.282 10.797] 11.046) 11.208} 43.333)
NET INCOME 9.288) 8.365) 9.072| 9.709] 36.434) 10.282) 10.797} 11.046) 11.208; 43.333)
FINANCIAL STATEMENT 1-01-XX_ | 1° Quater | 2° Quater| 3° Quater | 4° Quater 1° Quater| 2° Quater | 3° Quater | 4° Quater
ASSETS
Equipment (net of depreciation) 10.000} 9.375) 8.750] 8.125] 7.500] 6.875] 6.250] 5.625] 5.000]
Inventories 168.000] 172.200] _177.030|_—-202.377|_—_227.289] 251.810 275.979| 299.831| 323.398|
[Accounts receivables 49.750] 51.167 50.492 51.009] 51.475| 53.044! 53.421| 53.761 54.066|
Positive bank balance 50.000] 43.700 47.699] 37.624| 21.609 2.731 i) 0] 0
TOTAL ASSETS: 277.750] 276.442) 283.971 299.136| 307.874 314.460 335.651 359.217 382.465,
LIABILITIES
Equity 227.750| _236.109| _243.637|_—-251.802| 260.540] 269.794] 279.511) 289.453| 299.540]
Long terms debts 0} 0 iG) ) 0] 0 0] ) 0}
Short terms debts 50.000] 40.333 40.333] 47.333) 47.333 44.667 44.667| 44.667| 44.667|
Negative bank balance 0 i) ) ) i) 11.473| 25.098} 38.258]
Deferred income taxes 0} 0 I) te) 0] te) 0] 0] |
TOTAL LIABILITIES & EQUITY 277.750] 276.442) 283.971) 299.136) 307.874) 314.460, 335.651) 359.217) 382.465
° Due to privacy reasons all figures have been modified.
19
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20
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