Is Growth Always Good?

In the business world, growth is often treated as success. Higher sales, entry into new markets, a larger workforce, expanded production capacity or a rising firm value are all regarded as favourable developments. The question is whether a firm, as it grows, necessarily creates more economic value.

For growth to be meaningful, it must be supported by a sustainable business model, adequate profitability and a strong capacity to generate cash.

Firms face two basic strategic choices. An entrepreneur may concentrate on an existing market and build a small but financially sound business. Such a firm may grow more modestly; yet its need for external capital is limited, and ownership and managerial control remain higher. Alternatively, the firm may turn to larger markets and seek to expand its products, customers and revenues rapidly. In that case, as scale increases, so do the need for external finance, managerial complexity and the risk of failing to achieve profitability.

Growing and building a good business are not the same thing

A firm’s capacity to grow is shaped by such factors as the size of the market, the market’s rate of growth, the competitive structure of the industry, capital intensity, customers’ willingness to switch to new products, and the firm’s dependence on particular individuals. The growth capacity of a software company that can reach thousands of new customers without further capital investment is not the same as that of an industrial firm that must invest in new machinery, buildings or inventories for each additional sale.

High growth potential does not, however, mean that the firm will automatically become profitable. Unit economics, economies of scale and competitive advantages are decisive in delivering profitability. If the firm is operating above break-even and the unit selling price exceeds unit variable cost (a positive contribution margin), each additional unit sold makes a positive contribution, and growth supports profitability. By contrast, if each new sale brings with it high production, distribution or customer-acquisition costs (a negative contribution margin), larger scale can also enlarge losses.

Management must therefore look both at how far sales grow and at the extent to which those sales convert into profit and cash flow.

The risk in “grow first, profits will follow”

The notion of “growth first, profitability later” is not a sound general rule. For some firms the model can work. Companies operating in a large and rapidly growing market, with low capital intensity and strong economies of scale, may both grow quickly and achieve high profitability.

Those conditions are not present in every business.

Channelling more capital into a structurally flawed business model does not make the firm better; it can make it larger and more fragile.

Some firms, despite limited production volume, can reach a very high enterprise value through a strong brand, pricing power and high margins. This recalls an important fact: the size of a firm and the quality of a firm are not the same thing.

Why the point matters more for Türkiye

The argument is of particular importance for firms in Türkiye, because growth there often generates a substantial need for working capital and external finance.

For a manufacturing firm to raise sales, it must typically hold more raw materials and inventories, sell on credit to customers and expand capacity. An increase in turnover therefore also enlarges inventories and trade receivables.

Suppose a firm’s sales rise from TRY 100 million to TRY 150 million. At first sight a 50 per cent increase looks highly favourable. Yet to achieve that growth the firm may have to tie up additional resources of:

• TRY 15 million in inventories,
• TRY 20 million in trade receivables,
• TRY 10 million in capacity investment.

Financing the growth then requires about TRY 45 million of extra capital.

If that capital is financed with high-cost debt, the firm’s sales growth can cause financing expenses to rise even faster. Revenues increase, but net profit and the capacity to generate cash decline.

The decision criterion should be this:

How many additional lira of capital does each extra lira of sales require, and will the return on that capital cover its cost of finance?

As sales grow, EBITDA margin, operating cash flow, free cash flow, inventory and receivables turnover, the cash conversion cycle, the net debt/EBITDA ratio, interest coverage and return on invested capital should be monitored together.

The following relationship is of particular importance:

ROIC > Cost of Capital

So long as the return on invested capital exceeds the cost of capital, growth creates economic value. In the opposite case the firm expands its balance sheet as it grows, but may not increase its economic value.

That is why, if a choice is to be made between a firm whose sales grow by 40 per cent but whose debt rises by 80 per cent, whose cash conversion cycle lengthens and whose return on capital falls, and a firm whose sales grow by 15 per cent while its capacity to generate cash and its profitability improve, the second firm may be far healthier in financial terms.

The basic conclusion for Turkish companies is that growth is useful only insofar as it gives rise to value.

In economies where the cost of finance is high, uncontrolled growth can make firms more financially fragile rather than stronger.

Do not grow for the sake of growth. Grow if, as you grow, you generate more cash, use your capital more efficiently and earn a return above your cost of capital.

Success is not merely growing; it is being able to create more value as you grow.

The Growth–Profitability Matrix

The matrix below is taken from Aswath Damodaran’s note on the growth–profitability trade-off. The English terms are those used in the original.

Profitability	Limited growth	High growth
Very high / strong	Niche Star Limited growth; high margins and returns on capital, with very strong positive cash flows.	Lightning in a Bottle Rapid growth; high margins and returns on capital, with very strong positive cash flows. A rare and exceptionally successful combination.
Average / sustainable	Small Win Limited growth; modest margins and returns on capital, with strong and stable cash flows.	Field of Dreams Grow revenues first (scale), and build profitability and strong cash flows over time.
Low	Small Loss Limited growth; low margins and returns on capital, with positive but limited cash flows.	Field of Nightmares Grow revenues (scale), but even with economies of scale cannot generate sustainable profit over time.
Negative	Cut Your Losses Limited growth; negative margins and returns on capital, with negative cash flows. Shrinking, transforming or closing the business model comes onto the agenda.	Big and Broken Scale increases, but the fundamental problems in the business model are not resolved; losses and negative cash flows grow with the firm.

Horizontal axis: growth capacity. Vertical axis: profitability and return on capital. The table is taken from Aswath Damodaran’s note setting out the growth–profitability approach.

This essay was written with inspiration from Aswath Damodaran’s “The Scaling and Profitability Trade-off: Venture Capital's Weakest Link!”. https://www.linkedin.com/pulse/scaling-profitability-trade-off-venture-capitals-link-damodaran-co0tc/