Question

Can the sustainable growth rate of a company be greater than the internal growth rate?

Explain why and how.

Answer 1

Solution

(Note 'x' is referred to multiplication sign )

Yes

The sustainable growth rate of the company will be higher than the internal growth rate.

Let us see why

The internal growth rate is the maximum rate at which the company can grow without getting externally funded. Whatever percentage of growth the company is experiencing is solely through its own equity. The growth takes place when the company reinvests the earnings of the past year to get a better growth rate.

However the sustainable growth rate is the growth the company experiences when it follows it's own financial policy. Note that in the case of sustainable growth, the company takes certain debt element. This can be represented by calculating its leverage ratio like the Debt to Equity Ratio.

For a better understanding let us quantify the following data

Say, a company United Group has earnings of $60 million last year. United Group pays 60% dividend to its shareholders. The total assets in United Group's Balance sheet are $540 million. The equity of the company is $240 million.

Now,

Sustainable Growth Rate = Retention Ratio x Return on Equity

Sustainable Growth Rate = (1 - 60%) x ($60 million / $240 million )

Sustainable Growth Rate = 40% x 0.25 = 10%

Internal Growth Rate = % of retained earnings x Return on asset

Internal Growth Rate = (1 - Dividend Payout Ratio) x (Earnings / Total Assets)

Internal Growth Rate = (1 - 0.6) x ($60 million / $600 million)

Internal Growth Rate = 0.4 x 0.1 = 4%

Another way,

IGR = Reinvested earnings divided by total assets

IGR = (40% of $60 million) divided by $600 million

IGR = $24 million divided by $600 million

Internal Growth Rate = 4%

As seen above the the internal growth rate is lower than the sustainable growth rate. This is because the company is not using leverage (debt) at all. It only depends on the equity and the amount of profits it can retain. this reduces the overall growth in sales and affecting the growth rate of the company.

Understanding through formula

SGR = Retention Ratio x Return on equity

Therefore, SGR = (Reinvested earnings / net income) x (net income / equity)

Internal Growth Rate = Retention Rate x Return on assets

IGR = (1 - Dividend Payout Ratio) x ROA

IGR = (Reinvested earnings / net income) x (net income / total assets)

We can add equity to both numerator and denominator

IGR = (Reinvested earnings / net income) x (net income / equity) x (equity / total assets)

We can say that Internal Growth Rate is equal to Sustainable Growth Rate x (equity / assets) equity component

as Sustainable Growth Rate = (Reinvested earnings / net income) x (net income / equity)

In order to give better returns, external finance is required. If the company relies on the internal rate of growth depending on its available equity and retained earnings, the growth will not please the investors. The involvement of debt component is what makes the sustainable growth rate higher than internal growth rate.