In 1919, F. Donaldson Brown developed the Sustainable Growth Model (SGM), a financial performance management tool that transformed two industry giants, DuPont and General Motors Corp. More than 90 years later, the model still is widely studied and used.
Brown developed SGM (also known as the DuPont formula) when serving as DuPont’s treasurer, and he brought the concept to General Motors as chief financial officer. Many believe the powerful new financial analysis tool Brown pioneered helped these companies ascend to and maintain leadership positions in their respective industries.
SGM has demonstrated rare longevity among financial analysis tools, serving as the basis of a Harvard Business School case study, Brown Lumber, for more than 30 years. The key lesson from the Brown Lumber study was that the company, which appeared to be successful at first analysis, was trying to grow faster than its capital and income would support. In fact, it was on an unsustainable trajectory and would soon require infusions of capital to survive.
This model has remained popular for so long because it’s easy to use and understand. It pulls data from both the balance sheet and income statement, and provides a comprehensive view of a firm’s financial strengths and weaknesses.
How SGM works
The SGM formula consists of three financial ratios—profit margin, asset turnover, and leverage—multiplied by each other.
This is a financial metric that’s widely used and understood throughout the credit union movement.
Next, if you multiply ROA by leverage, you can cancel “assets” in the denominator of ROA and the numerator of leverage. This leaves you with profits divided by capital, which equals return on equity (ROE).
Brown’s key finding in 1919, which still applies today, was that ROE is equal to the rate at which a firm can grow its assets on a sustainable basis. If a firm wants to grow faster than its current ROE, it must improve at least one of the three ratios—profit margin, asset turnover, or leverage—without depressing the other two.
While ROE hasn’t been widely used in the credit union movement (because credit unions don’t have traditional stockholders), the formula works perfectly as a measure of capacity to grow assets. In fact, because credit unions don’t pay income tax or stock-based dividends, and they don’t generally have access to secondary capital, the formula can be applied in a simpler, cleaner fashion than in many other industries.
Continuing down the chart, note that ROA is equal to profit margin multiplied by asset turnover. Asset turnover can be thought of simply as how much revenue a firm can derive from its asset base. Some industries (i.e., grocery) have low profit margins but very high asset turnover levels. If a grocery store doesn't turn over its inventory of fresh merchandise regularly, it will soon be out of business. The credit union movement, on average, has low asset turnover (typically 3% to 7%), but relatively higher profit margins.
Moving further down the chart, we see that profit margin is equal to net income divided by net revenue. Net income, in turn, is equal to net revenue minus total expenses. Most credit unions have three primary sources of net revenue: Net interest income (i.e., spread income), fees and other operating income (i.e., non-interest income), and nonoperating income. In a typical year, most credit unions generate little non-operating income.
Similarly, most credit unions have two primary sources of total expenses: loan loss provisions and operating expenses. You can apply this model to the credit union movement as a whole, to individual credit unions, or to categories of credit unions.
A key insight emerging from SGM is that credit unions have six primary financial factors or “levers” they can manage to improve ROE and sustainable asset growth. The levers are leverage, asset turnover, spread income, fee income, loan losses, and operating expenses.
As figure to the right demonstrates, the credit union movement’s sustainable growth rate (ROE) has declined over a 25-year period. The early part of this decline (1985 to 2000) can be attributed primarily to rising credit union net-worth levels, which translated into declining leverage. That isn’t a bad thing. The more recent decline (2000 to 2009), however, can be attributed almost entirely to declining ROA. That’s not healthy, and it’s a situation that requires our collective attention.
This background is an updated version of the second article in a three part series we wrote for Credit Union Magazine. Feel free to check out the original series (subscription site)!