Which of the following is a disadvantage of growth by means of external growth strategies?

External Growth Definition

External Growth refers to the inorganic growth strategy wherein a company uses external resources and capabilities, but not the available internal resources, to expand its business activities. This strategy results in an increase in sales and profitability through purchasing other companies or building a business relationship with them.

Strategies of External Growth

The strategies can be broadly classified into two primary vehicles: mergers & acquisitions and strategic alliances. The differentiating factor between the two strategies is how the ownership changes. In mergers & acquisitions, the ownership between the companies gets exchanged, while in a strategic alliance, businesses can retain their independence while pursuing their collective objectives.

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• Mergers and Acquisitions: Typically, the companies exchange their ownership in a merger and acquisition transaction. A mergerMerger refers to a strategic process whereby two or more companies mutually form a new single legal venture. For example, in 2015, ketchup maker H.J. Heinz Co and Kraft Foods Group Inc merged their business to become Kraft Heinz Company, a leading global food and beverage firm.read more refers to a transaction wherein two companies combine to form a new entity with the consent of the boards of both the involved companies. On the other hand, an acquisitionAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion.read more refers to a transaction wherein the acquiring company bids to purchase a controlling stake in the target company, either with the approval of the board and shareholders of the target company or without it.
• Strategic Alliances: A strategic alliance is slightly different from mergers & acquisitions as it doesn’t involve a complete exchange of ownership between the companies involved. Rather, the participating companies pool their resources and assets to achieve collective goals while retaining their independence under this transaction. A strategic alliance can either be an equity alliance or a non-equity alliance.

Business

There are several reasons that businesses opt for external growth, and some of the major ones that drive this strategy are as follows:

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• Limited resources constrain the growth of smaller businesses, and in such a scenario, the external growth strategy fits in perfectly.
• This strategy results in a reduction in the cost of production, an increase in turnover rate, and higher profitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more.
• With the increase in size, the firms can control a larger share of resources, which results in better bargaining power.
•  This strategy also facilitates a combination of non-managerial and managerial skills of different firms into one, which results in higher performance standards.

Uses

Some of the primary uses of this strategy are as follows:

• It allows companies to access newer and bigger markets.
• It helps companies to grow bog so that they can command more market power.
• At times companies acquire another company to obtain access to noble technology or a stronger brand.
• It facilitates product and service diversification.
• It helps in increasing the operational efficiency of a business.

External Growth vs. Internal Growth

• In internal growthInternal Growth Rate is calculated by multiplying ROA of the company with the retention ratio of the company. The equation is as follows: IGR = ROA*r/(1-ROA*r).read more, in-house resources are used to grow operations, which can finance either internally or from the debt and equity market. On the other hand, a company engages in merger and acquisition deals to grow in external growth.
•  Internal growth focuses on improving the existing operational efficiency and cost efficiencies. On the other hand, external growth emphasizes branding, marketing, advertising, etc.
• Implementation of an internal growth strategy takes a longer period to yield results, while external growth is a relatively faster approach.
• An internal growth strategy involves lower risk than an external growth strategy, given that the latter is more expensive.

Advantages

Some of the advantages are as follows:

• It helps eliminate inefficient expenses while promoting more cooperation among the participating companies.
• It enables better utilization of resources that can increase profitability.
• It helps penetrate new markets, acquire more customers, and product diversification.
• It offers the benefits of synergy, which means that the collective output of the participating companies is more than what each company can produce
• Increase in size results in economies of scaleEconomies of scale are the cost advantage a business achieves due to large-scale production and higher efficiency. read more.

Disadvantages

Some of the disadvantages are as follows:

• This strategy is quite expensive as compared to the internal growth strategy.
• It results in a concentration of power in the hands of the few who may end up misusing it.
• Merger and acquisition deals result in large-sized companies that may resort to monopoly.
• The alliance may end up in a big failure if there is a vast difference in the combined companies’ level of competency and ability.

Recommended Articles

This has been a guide to External Growth and its definition. Here we discuss strategies, business, and uses of external growth and advantages and disadvantages. You may learn more about financing from the following articles –

• Organic Growth
• Dividend Growth
• Growth Rate Formula
• Sustainable Growth Rate Formula