Question

How does a company assess its sustainable growth rate (SGR)?

·        How does a firm use the SGR in decision making?

·        What are the consequences for a firm that grows a higher rate than its SGR?

·        What are the consequences for a firm that grows at a lower rate than its SGR?

Consider the following ideas to include in your answer:

·        Which variables are used in calculating the SGR?

·        How does a firm use the SGR in choosing a financing option?

·        How does a firm finance a growth that is higher than its SGR?

·        What is the opportunity cost for a firm that grows at a lower rate than its SGR?

Answer 1

Concept of Sustainable Growth Rate:

The sustainable growth rate (SGR) is the most realistic rate of growth that a firm can sustain without having to increase financial leverage or look for outside financing. This metrics considers the following assumption:

(1) the company will grow sales as rapidly as market conditions permit,

(2) management is unwilling to issue new shares, and

(3) the company maintain its capital structure and dividend policy.

This growth rate is considered sustainable as the company is growing from internally generated funds that is, retained earnings.

Formula to calculate SGR:

SGR = Return on Equity * Business Retention Rate

Where:

ROE is essentially the amount of profit that the company has generated from the money that it took from its shareholders. The components of ROE are:

R0E = (Net Income / Shareholders Equity)

Net Income = Profit attributable to the shareholders

Shareholders Equity = (Total Assets – Total Liabilities)

Business Retention Rate is the amount of profit that the company has kept for further growth of business after the company has paid out the dividends to the shareholders. This is important as it takes into consideration the fact that the company would be paying dividends in future.

Retention Rate = (Earnings available to owners-Dividend)/Earnings available to owners

For Eg: If a company has a ROE of 10% and a payout ratio of 50%, for example, its SGR is calculated by taking 0.10 and multiplying it by (1 - 0.50), giving the company a SGR of 0.05. This means that the company can safely grow at a rate of 5% using its own revenue and remain self-sustaining. If the company wants to accelerate its growth past this threshold to 6%, it needs to seek outside funding.

About Actual Growth Rate:

The actual growth rate in a company is simply the increase in sales over a given period of time. Divide the sales figure from your starting point by your most recent sales figure.

Comparing Actual and Sustainable growth rate.

The business can grow faster, slower, or just at the sustainable growth rate.

• Actual Growth exceeding SGR: While rapid growth might seem like a positive indicator, a growth rate that exceeds the sustainable growth rate may mean that the growth is not sustainable or the business doesn’t have enough cash on hand to meet business needs at the rate the business is growing.

It means that the business needs to finance increases in operations by either issuing new stock, taking on new debt, reducing dividends, or increasing profit margins.

• Actual growth less than SGR : A lower actual growth rate than the calculated sustainable growth rate may serve as evidence that your business isn’t performing to the potential and not using its financial resources to maximize owners’ wealth. and corrective measures needs to be taken

Uses of SGR in financing:

As discussed already. the sustainable growth rate is a useful tool that allows managers to determine how quickly a company can grow, whether retained earnings are sufficient to finance the company’s growth, or what will be the external financial needs for future growth of the company.

Hence, Sustainable growth can help in determining the company’s optimum capital structure.

This concept is consistent with the idea of a target capital structure: a company will try to maintain a relatively constant capital structure and accordingly choose its financing, even though there will be slight year-to-year deviations in the actual capital structure.