Academic journal article Journal of Financial Management & Analysis

Econometric Analysis of Functional Relationship between Inflation and Growth of Firms in South Africa: Empirical Research Findings

Academic journal article Journal of Financial Management & Analysis

Econometric Analysis of Functional Relationship between Inflation and Growth of Firms in South Africa: Empirical Research Findings

Article excerpt


Despite some controversy, it is generally accepted that inflation deters from a firm's growth potential. The primary objective of this research is to determine whether, using financial performance data of local firms, this has been true during South Africa's period of isolation. A secondary objective is to explore the impact of inflation on firm growth using alternative measures of inflation. In addition this research will investigate the extent to which firm management may be able to mitigate the damaging effects of inflation. Using an enhanced version of the sustainable growth modeling framework, various hypotheses are tested to identify the controllable and uncontrollable factors that collectively determine the extent to which firm performance is impaired by inflation.


The sustainable growth model describes the annual growth rate of real sales that can be maintained given certain financial policies and assumptions describing the firm's technological and competitive constraints. Higgins1 put forth die original work on the sustainable growth problem. In the original Higgins framework, which did not address inflation, the firm's sustainable growth is determined by additions to retained earnings (via undistributed profits) and the resultant allowable increase in debt (via predetermined debt/equity ratio) to finance asset expansion and sales.

Early applications of this framework focus on the relationship between growth and changes in one or more of the constraining ratios rather man the realistic inclusion of inflation. Extensions of the model into the corporate planning literature by Ellsworth2, Van Home3, and Murray, et al.4, for example, assume inflation will not impact growth unless the firm has a positive investment in net working capital. The reasoning here is mat inflation will not reduce firm growth unless there is a requirement to finance inflation induced increases in current assets.*

Likewise, use of the sustainable growth framework to examine tradeoffs between operating and financial parameters by Lewellen*, Seitz7, Fruhan*, Donaldson', Clark10; ChurchhiU and Mullins and Adam, et. al.11, simply assume a neutral impact of inflation. (Inflation was not the primary focus of these studies and it was not included in model specification in either a robust or a realistic fashion.)

An enhancement of the sustainable growth model by Doyle et al.12 more accurately captures the influence of inflation on capital intensity and profitability within the sustainable growth model. It is this formulation of sustainable growth that is briefly summarized below and will be used to empirically validate several hypotheses concerning firm growth**.

A recent attempt by N'Cho-Oguie, etal.,13 was made to empirically validate similar hypotheses utilizing data from multiple countries over different time periods. Obvious difficulties with this approach include different accounting standards as well as difficulties associated with temporal comparison of financial performance statistics. The research presented below reflects firm performance data produced under the same accounting standards umbrella over the same time period. In addition, the data set utilized allows for alternative measures of inflation to be tested as to their impact on firm growth.

Sustainable Growth Model

The formal methodology used below is similar to that employed in the aforementioned sustainable growth literature. It is shown that by specifying given levels of financial leverage, capitalization, profit retention, asset turnover, and oüier assumptions describing the firm's operating environment, it is possible to calculate the firm's resultant level of real sales growth. The structural equations, which capture these relationships, are specified and solved to find the firm's growth as a function of specific operating and financial variables.

Using sample data we first demonstrate the unequivocal effect of inflation; i. …

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