The sustainable growth rate is an important financial metric that helps business leaders understand what stage of the business cycle they are in. At its core, the metric sheds light on the absolute maximum amount of growth the business can achieve before it requires outside capital.
In this post, we will cover what the sustainable growth rate is, why it matters, how to calculate it, and how to interpret it.
What Is The Sustainable Growth Rate (SGR)?
In simple terms, the sustainable growth rate is the rate at which a business can grow without acquiring outside financing. Usually, when a business looks at growing a determination is made as to whether it is more advantageous to use debt or issue new equity. Understanding how much it can grow before doing so is very important.
For many businesses, the decision to issue new equity or take on debt is a difficult decision for two reasons. First, acquiring debt has serious implications for a business, especially one that is growing. It is important for analysts to understand how much debt can be utilized, what the return on the debt would be, and how it impacts the financial performance of the business.
Secondly, the issuance of new equity comes at the cost of ownership. Many small business owners prefer to retain as much ownership as possible. Additionally, new equity dilutes the previous stakeholder’s equity.
Why Sustainable Growth Rate Matters
Business leaders should be keenly aware of exactly how far their internal operations can carry them. Understanding the SGR allows managers to create and implement various growth strategies.
It is very common for young companies, often referred to as “growth companies,” to utilize a combination of debt and equity financing to achieve their growth trajectories. As they mature from the growth stage to stability, financial leaders are faced with several decisions.
One of the most important decisions they face is whether or not to modify the existing capital structure to support further growth and if so, how. Because of this, they rely on the sustainable growth rate to indicate what stage of the business cycle the business is in, which is then used as a guide to help create appropriate financial plans.
How To Calculate Sustainable Growth Rate
Calculating sustainable growth rate relies on two separate financial metrics and this is the the formula for calculating it:
SGR=ROE×(1-Dividend Payout Ratio )
SGR = Sustainable Growth Rate
ROE= Net Income ÷Average Shareholder’s Equity
Dividend Payout Ratio = Dividends Paid÷Net Income
Return on equity (REO) is a measure of profitability and compares the net income of a business to its average equity. Holding all things equal, ROE goes up if net income rises or equity drops. Conversely, ROE can go down if net income drops or equity rises.
The dividend payout ratio is the percentage of profits that are paid to equity holders. It is often used to assess the maturity of a business.
Growth oriented companies for example, might choose to withhold dividends in favor of funding new products, expansion, or marketing. In these cases, dividends might be equal to zero, which would make the dividend payout ratio 0% and therefore make the SGR equal to the Return on Equity.
Interpreting Sustainable Growth Rate
Typically, a business with a high sustainable growth rate is one that is maximizing sales efforts and/or generating high profit margins. It is also an indicator that the business is effectively managing its inventory, receivables, and payables.
As time goes on and the business matures, the SGR usually declines as new market entrants begin to eat away at margins or diminishing demand drivers reduce the pricing power of the business.
SGR is often used to help shed light on whether a business is managing its operations efficiently. The reason for this is that the sustainable growth rate is driven by net income and net income can be increased or decreased depending on how efficient a business is operating.
As businesses manage inventory and vendor payments more effectively, they can drive up profit margins, increasing their sustainable growth rate.