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A company’s growth is primarily reliant on its financial sources. If the company is bootstrapped or relies only on revenue, it must be cautious while preparing its budget to reduce useless expenses and increase profitability while expanding to new demographics. On the other hand, if the company relies on external sources of funding, such as bank finance or public funds, the risk factor rises as the company’s growth potential increases.
To explore the relationship between leveraging internal and external financing, you must first comprehend the concept of sustainable growth rate, which we will cover in this article.
What is a sustainable growth rate?
The Sustainable Growth Rate (SGR) represents the approximate rate at which a company can expand if it continues with its existing debt and equity financing mix. In simpler terms, it signifies the pace of growth a company can sustain without relying on external sources for additional funds.
The sustainable growth rate analysis serves as an indicator of a company’s life cycle stage:
- Early-stage companies: These startups often rely on self-funding (retained earnings) until external financing becomes necessary. Their SGR may be lower due to limited profitability.
- Mature companies: Profitable and established firms can choose from three funding sources: internal funding (retained earnings), equity issuances, or debt issuances. Their SGR reflects their growth potential.
Remember, while a higher SGR suggests a greater upside, it also entails risks such as earnings volatility and default.
Sustainable growth rate assumptions
The self sustainable growth rate works on the following assumptions:
- SGR assumes that a company retains a portion of its earnings rather than distributing all profits as dividends. The proportion of these earnings funds the additional assets required for growth.
- The company has a stable dividend policy over time. Any significant changes in the dividend payout ratio would affect the SGR.
- SGR presumes that the company has an ideal debt and equity financing mix.
- The company is assumed to push for sales growth up to the maximum level possible through its internal financing capabilities.
- The company manages its operations efficiently through optimal inventory levels, receivables, and payables to support the desired growth rate.
- The SGR assumes relatively stable market conditions. High volatility in market conditions could necessitate adjustments to the growth strategy.
- The underlying assumption is that the demand for the company’s products or services will keep growing or remain steady.
- The availability of required resources, such as raw materials and labour, is assumed to be consistent with no significant shortages or price hikes.
Sustainable growth rate formula
You can compute SGR using the following formula to know how to calculate sustainable growth rate.
SGR = ROI × b
Where:
- ROE, the return on equity, calculates a company’s profitability by showing how much profit it makes from shareholders’ investments.
- (b) is the retention ratio, the portion of earnings kept back in the company rather than paid out as dividends.
Computing ROE
Employ the following formula to compute return on equity.
(ROE) = (Net Income ÷ Shareholders’ Equity)
Note: Net Income is the profit after all expenses, taxes, and dividends have been paid. On the other hand, shareholder’s Equity is the total value of the company’s assets minus its liabilities.
Computing Retention Ratio
Utilise the following formula to compute this ratio:
(b) = (1 – Dividend Payout Ratio)
The Dividend Payout Ratio is the part of net earnings paid to shareholders as dividends. It is the part of profits reinvested in the company.
Sustainable growth rate calculation
Let’s put the sustainable growth rate analysis formula into practice with an example.
Let’s call a company ‘XYZ’, with a net income of Rs 10,00,000 and shareholder’s equity of Rs 50,00,000. They decide to pay out Rs 2,00,000 in dividends.
Here is how to calculate the sustainable growth rate.
- Calculate ROE
ROE = (Rs 10,00,000 ÷ Rs 50,00,000)
ROE =0.20 or 20%
- Calculate the retention ratio
b = 1 – (Rs 2,00,000 – Rs 10,00,000)
b = 0.80 or 80%
- Calculate SGR
SGR = (0.20 × 0.80)
SGR = 0.16 or 16%
Company XYZ can sustainably grow at a rate of 16% per year without needing additional financing.
Distinction between internal growth rate and sustainable growth rate
| Parameters | Internal Growth Rate | Sustainable Growth Rate | Price-to-earnings (P/E) Ratio |
| Definition | IGR is the maximum growth rate a company can achieve without resorting to external financing. It reflects the company’s ability to grow using only its retained earnings. | SGR is the maximum growth rate a company can sustain while maintaining its existing financial leverage (debt-to-equity ratio). It includes using both retained earnings and new debt to finance growth | PEG ratio is a stock’s price-to-earnings (P/E) ratio divided by its revenue growth rate for a specified period. |
| Financing | Relies solely on internal financing, i.e., reinvestment of retained earnings | Utilises a mix of retained earnings and new debt while keeping the debt-to-equity ratio constant. | NA |
| Capital Structure | Does not alter the capital structure since no new debt or equity is introduced. | Maintains the current capital structure, balancing the debt-financed growth with increased equity from retained earnings. | NA |
| Purpose | Indicates the growth potential without changing the financial risk profile of the company. | Indicates how fast a company can grow sales and assets without issuing new equity and without increasing its financial risk. | Investors use P/E ratios to determine a stock’s relative value by considering earnings growth and the P/E ratio. |
| Limitations | Limited by the amount of earnings a company can retain and reinvest. | Limited by the company’s ability to effectively manage additional debt without deteriorating its financial health. | It can be misleading if future growth rates are overestimated or the company’s earnings are volatile. |
Conclusion
SGR is a useful tool for management to plan for growth while avoiding over-leverage. It helps make strategic decisions about investment, financing, and dividend policies. A company growing faster than its SGR may need external financing, which could increase financial risk. Conversely, growing slower than the SGR might indicate the company is not utilising its full potential. To know more, read our blogs.
FAQs
SGR refers to the highest growth rate a company can maintain without needing to secure additional funding through equity or debt.
The sustainable growth rate (SGR) assumes a company can grow using internal revenues without additional debt or equity. It presumes a constant dividend payout ratio, optimal inventory management, a focus on high-margin products, and efficient sales and receivables management to maintain cash flow and profit margins.
The terminal growth rate is used to estimate free cash flows beyond the forecast period.
A company’s capital structure (debt-to-equity mix) significantly influences how it finances its growth. A higher debt ratio may lead to greater growth potential and risk. Conversely, relying more on equity financing could limit growth. Striking the ideal balance is crucial for achieving a sustainable growth rate.
A negative sustainable growth rate indicates potential financial distress and a need for immediate strategic reassessment.