Question

5. For Smith Corp. (above), what is the sustainable growth rate?

Answer 1

Sustainable Growth Rate – SGR

The sustainable growth rate (SGR) is the maximum rate of growth that a company or social enterprise can sustain without having to finance growth with additional equity or debt. The SGR involves maximizing sales and revenue growth without increasing financial leverage. Achieving the SGR can help a company prevent being over-leveraged and avoid financial distress.

The sustainable growth rate is the rate of growth that a company can expect to see in the long term. Often referred to as G, the sustainable growth rate can be calculated by multiplying a company’s earnings retention rate by its return on equity. The growth rate can be calculated on a historical basis and averaged in order to determine the company’s average growth rate since its inception.

The sustainable growth rate is an indicator of what stage a company is in, during its life cycle. Understanding where a company is in its life cycle is important. The position often determines corporate finance objectives, such as which sources of financing to use, dividend payout policies, and overall competitive strategy.

The growth ratio can also be used by creditors to determine the likelihood of a company defaulting on its loans. A high growth rate may indicate the company is focusing on investing in R&D and NPV-positive projects, which may delay the repayment of debt. A high-growth-rate company is generally considered riskier, as it likely sees greater earnings volatility from period to period.

Operations and the SGR

For a company to operate above its SGR, it would need to maximize sales efforts and focus on high-margin products and services. Also, inventory management is important and management must have an understanding of the ongoing inventory needed to match and sustain the company's sales level.

The SGR of a company can help identify whether it's managing day-to-day operations properly, including paying its bills and getting paid on time. Managing accounts payable, or short-term debts payable to suppliers, needs to be managed in a timely manner to keep cash flow running smoothly.

The Unsustainability of High SGRs

Sustaining a high SGR in the long term can prove difficult for most companies. As sales revenue increases, a company tends to reach a sales saturation point with its products. As a result, to maintain the growth rate, companies need to expand into new or other products, which might have lower profit margins. The lower margins could decrease profitability, strain financial resources, and potentially lead to a need for new financing to sustain growth. On the other hand, companies that fail to attain their SGR are at risk of stagnation.

The SGR calculation assumes that a company wants to maintain a target capital structure of debt and equity, maintain a static dividend payout ratio and accelerate sales as quickly as the organization allows.

When Growth Exceeds the Sustainable Growth Rate – SGR

There are cases when a company's growth becomes greater than what it can self-fund. In these cases, the firm must devise a financial strategy that raises the capital needed to fund its rapid growth. The company can issue equity, increase financial leverage through debt, reduce dividend payouts, or increase profit margins by maximizing the efficiency of its revenue. All of these factors can increase the company's SGR.

Limitations of the Sustainable Growth Rate

Achieving SGR is every company's goal, but some headwinds can stop a business from growing and achieving its optimal SGR.

Consumer trends and economic conditions can help a business achieve sustainable growth or cause the firm to miss it completely. Consumers with less disposable income are traditionally more conservative with spending, making them discriminating buyers. Companies compete for the business of these customers by slashing prices and potentially decreasing growth. Companies also invest money into new product development to try to maintain existing customers and grow market share, which can cut into a company's ability to grow and achieve its SGR.

A company's forecasting and business planning can detract from its ability to achieve sustainable growth in the long-term. Companies sometimes confuse their growth strategy with growth capability and miscalculate their optimal SGR. If long-term planning is poor, a company might achieve high growth in the short term but won't sustain it in the long term.

In the long-term, companies need to reinvest in themselves through the purchase of fixed assets, which are property, plant, and equipment. As a result, the company may need financing to fund its long-term growth through investment.

Capital-intensive industries like oil and gas need to use a combination of debt and equity financing in order to keep operating since their equipment such as oil drilling machines and oil rigs are so expensive.

It's important to compare a company's SGR with similar companies in its industry to achieve a fair comparison and meaningful benchmark. Learn about how companies are affected by their industry's financial lifecycle.