If a company wishes to expand or sustain its success in the future, it must consider and evaluate a number of factors before making any decisions. It is critical for business leaders to assess the organization, research the competitive market, and review the organization’s financial health and performance. The business’s sustainable growth rate is an important figure to consider. In this article, we will discuss what the sustainable growth rate is and why it is important, as well as provide the formula to calculate, a step-by-step guide, and examples to help you learn its calculation.
What is the Sustainable Growth Rate (SGR)?
The sustainable growth rate (SGR) is the maximum rate of growth that a company or social enterprise can sustain without requiring additional equity or debt to finance growth. In other words, it is the rate at which the company can expand while relying solely on internal revenue and not borrowing from outside sources. The SGR entails increasing sales and revenue without increasing financial leverage. Furthermore, obtaining the SGR can assist a company in avoiding over-leverage and financial distress.
First, determine or calculate the company’s return on equity (ROE). ROE compares a company’s net income to its shareholders’ equity to determine its profitability.
Then, subtract the dividend payout ratio of the company from 1. The dividend payout ratio is the percentage of earnings per share paid out as dividends to shareholders. Finally, multiply the difference by the company’s ROE.
Understanding Sustainable Growth Rates
A company’s SGR can help determine whether it is properly managing day-to-day operations, such as paying bills and receiving payments on time. The rate is a long-term rate that is used to determine a company’s stage. Accounts payable must be managed in a timely manner in order to keep the cash flow flowing smoothly.
To operate above its SGR, a company must maximize sales efforts and focus on high-margin products and services. Inventory management is also critical, and management must understand the ongoing inventory required to match and sustain the company’s sales level.
Accounts Receivable Management
Managing accounts receivable collection is also critical to maintaining cash flow and profit margins. Accounts receivable represent money owed to the company by customers. The longer a company waits to collect receivables, the more likely it will experience cash flow shortfalls and struggle to fund its operations properly. As a result, to compensate for the cash flow shortfall, the company would need to incur additional debt or equity. Companies with low SGR may not be effectively managing their payables and receivables.
High Sustainable Growth Rates
Maintaining a high SGR over time can be difficult for most businesses. As a company’s revenue grows, its products tend to reach a sales saturation point. As a result, in order to maintain their growth rate, businesses must diversify into new or different products, which may have lower profit margins. Lower margins may reduce profitability, strain financial resources, and potentially necessitate new financing to sustain growth. On the other hand, companies that fail to meet their SGR risk stagnation.
The SGR calculation assumes that a company wants to maintain a target debt-equity capital structure, a static dividend payout ratio, and accelerate sales as quickly as the organization allows.
How to Calculate the Sustainable Growth Rate
The sustainable growth rate is the rate of growth that a company can maintain with its current capital structure. The capital structure of a company refers to how it funds its current (and future) growth, i.e., the mix of debt and equity used to fund operations and asset purchases.
Most early-stage companies that are either unprofitable or barely profitable are self-funded until they require external financing, typically in the form of equity issuances. Mature businesses that are profitable and have established market positions can raise funds from three sources:
- Internal Funding: Businesses can use their retained earnings to fund themselves (i.e. the accumulated net earnings not paid out as dividends to shareholders).
- Equity Issues: Businesses can raise capital by selling off pieces of ownership to institutional and/or retail investors.
- Debt Issuances: Companies can raise capital through borrowing agreements, in which lenders provide capital in exchange for interest payments and principal repayment at maturity.
The Formula for the Sustainable Growth Rate (SGR)
The formula to calculate the sustainable growth rate (IGR) consists of three steps:
- Step1: First, subtract the dividend payout ratio from one to calculate the retention ratio.
- Step2: The return on equity (ROE) is then calculated by dividing net income by the average shareholder’s equity balance.
- Step3: Finally, the sustainable growth rate is calculated by multiplying the retention ratio by the return on equity (ROE).
You calculate the sustainable growth rate by multiplying the earnings retention rate by the return on equity of the company. The formula to calculate the sustainable growth rate is as follows:
Sustainable Growth Rate = Retention rate X Return on Equity
Sustainable Growth Rate Formula
Where:
- Retention Rate – [(Net Income – Dividends)/Net Income]. This is the percentage of earnings that the company has not distributed as dividends. In other words, the amount of profit retained by the company, where Net Income – Dividends equals Retained Earnings.
- Return on Equity – (Net Income/Total Shareholder’s Equity). This represents the number of return investors has received in relation to the profit generated by the company.
A very high growth rate indicates that a company is still rapidly expanding. As a result, the company may be spending a large portion of its earnings on R & D and may not have much cash left over to make debt payments. As a result, a growing company may benefit more from equity financing and stock issuance to fund its operations.
Another reason why issuing equity may be a good idea for growing businesses is that growing businesses can better compensate equity investors. Stockholders seek capital gains, which means the company avoids making costly periodic cash payments. Instead, funds can be directed toward business development.
Read also: EQUITY MULTIPLIER: Definition, Formula, and Calculations
The dividend payout ratio is the percentage of earnings per share (EPS) paid out as dividends to shareholders; thus, subtracting the percentage paid out as dividends from one yield the retention ratio.
The retention ratio is the percentage of net income that is retained rather than distributed as dividends to shareholders.
The return on equity (ROE) of a company measures its profitability in relation to each dollar of equity investment contributed by its shareholders.
For example, if a company has a 10% return on equity (ROE) and a 20% dividend payout ratio, the sustainable growth rate is 8%.
Sustainable Growth Rate (SGR) = (1 – 20%) 10%
SGR = 0.80 x 0.10 = 8.0%
If management does not adjust the capital structure and operations remain consistent with historical performance, the company can grow at an annual rate of 8%.
Sustainable Growth Rate Calculation
Assume a company’s financials are as follows.
- Net Income attributable to Common Shareholders = $50 million
- The weighted average number of outstanding shares = 10 million
- Dividend per year = $25 million
Using those assumptions, earnings per share (EPS) and dividend per share (DPS) can be calculated.
- Earnings Per Share (EPS) = $50 million ÷ 10 million = $5.00
- Dividend Per Share (DPS) = $25 million ÷ 10 million = $2.50
We use “Net Income to Common Shareholders” instead of “Net Income” because net income attributable to preferred stockholders should not be included (e.g. preferred dividends).
Next, subtract the payout ratio from one to calculate the retention ratio:
Retention Ratio = 1 – ($2.50 ÷ $5.00) = 50%
Given that high payout ratios are often indicative of a highly profitable company with a stable outlook, we can safely assume that our company is relatively mature.
Following that, we’ll compute the return on equity (ROE) by dividing net income by the average shareholder’s equity, which we’ll assume is $200 million.
Return on Equity (ROE) = $50 million ÷ $200 million
ROE = 25%
Finally, multiplying the retention ratio by the ROE yields the sustainable growth rate (SGR).
Sustainable Growth Rate (SGR) = 50% 25%
SGR = 12.5%
Examples of Sustainable Growth Rates
Use the following examples to help you understand how to calculate the sustainable growth rate:
Known Dividend Payout Ratio
Before deciding whether or not to sell basketballs, Bradley Baseball wants to determine its sustainable growth rate. The previous year’s net income was $1,000,000, and the company has $15,000,000 in shareholder equity. It has a 0.6 dividend payout retention ratio.
The accountant starts by dividing 1,000,000 by 15,000,000 to get a return on equity of 0.067 percent, or 6.7 percent. The retention rate of the company is then calculated as 0.4 by subtracting the dividend payout retention rate of 0.6 from 1. The accountant multiplies 0.4 by 6.7 to get a result of 2.68, indicating that Bradley Baseballs’ sustainable growth rate is 2.68 percent, which is relatively low.
Unknown Dividend Payout Ratio
Isabella’s Ice Cream Shop wants to know what its sustainable growth rate is before deciding whether to add a bakery. The previous year’s net income was $500,000, and shareholder equity was $2,000,000. By dividing 500,000 by 2,000,000, the shop’s accountant calculates a return on equity of 0.25 or 25%.
The accountant is aware that there are two dividends per share and that earnings per share are $4. They calculate a dividend payout ratio of 0.5, which yields a retention ratio of 0.5 after subtracting the amount from 1. The accountant multiplies 25 by 0.5 to get the sustainable growth rate of 12.5. This indicates that Isabella’s Ice Cream Shop’s sustainable growth rate is 12.5 percent, which is a fairly high growth rate.
What Is the Significance of a Sustainable Growth Rate?
A sustainable growth rate is critical for businesses of all sizes. It indicates the stage of a company’s life cycle and may help determine the risks associated with or the likelihood of a company’s default. This rate can assist small businesses in determining what they can sustain or pursue without taking out another bank loan or spending more of their own money. Furthermore, it can assist large corporations in determining whether they have sufficient capital to achieve their strategic objectives.
How Can a Company Boost Growth?
There are numerous ways for a company to expand. A CEO could deliver a keynote address that motivates customers. A company could increase growth by cutting costs such as dividends or unprofitable divisions, or it could do a product rollout designed to maximize sales.
Internal Growth Rate vs. Sustainable Growth Rate
The internal growth rate is the greatest rate at which a corporation can expand without relying on outside funding (e.g. equity or debt issuances).
The IGR presupposes that the company’s retained earnings will be used solely to fund operations.
In contrast, the sustainable growth rate (SGR) incorporates the impact of external funding while maintaining the existing capital structure constant.
Because the SGR takes into account leverage, which enhances both the potential upside and downside in returns, it should be higher than the IGR.
Conclusion
Companies must keep track of their growth rates, so the SGR is calculated on a regular basis. There may be a point where the rate is sustained at a high level, but this stretches the company thin and may deplete its cash reserves. Companies will typically consider outside financing at this point.
Sustainable Growth Rate FAQs
What is meant by sustainable growth?
Today, sustainable growth is defined as growth that is repeatable, ethical, and accountable to and for current and future communities. And it’s critical to any company’s long-term success.
How do you find sustainable growth rate?
The sustainable growth rate is calculated by multiplying the company’s return on equity by 1 and subtracting the dividend payout ratio. Another method is to multiply the retention rate by the return on equity.
How do you maintain sustainable growth rate?
- To raise new funds, equity must be sold.
- Increase debt financing.
- Dividend payments to shareholders should be reduced.
- Boost your profit margins.
- Reduce the total asset turnover.
What is sustainable growth equation?
Sustainable Growth Rate = Return on Equity (ROE) * Retention Rate is the formula for calculating the sustainable growth rate. If no direct information on ROE is provided, it can be calculated as follows: ROE is calculated as Net Income/Equity. The retention rate is the rate of earnings that a company reinvests in its operations.
