Sustainable growth rates are essential for business because they determine the company's growth and enterprise value. A sustainable growth rate is a very effective way of evaluating and forecasting the maximum speed a company grow and manage without an infusion of cash.
In this article, we'll cover what sustainable growth rate is, why it's so crucial for businesses, and how to calculate the sustainable growth rate.
Sustainable growth refers to the rate at which a company can grow its net income without simultaneously raising equity or debt financing.
A sustainable growth rate is essential for every business because it indicates possible future cash flow and gives an accurate or near-accurate forecast of sales and revenue growth. Such a formula is necessary for both large and small businesses to develop long-term planning for their business, track their current sales efforts, and maximize sales if required.
A company's sustainable growth rate should be distinct from its operational growth rate. Although these two terms are similar in considering the company's earnings, they differ.
The significant difference between these two terms is the "debt profile." While operational growth rates consider the borrowed funds or additional financing from a company's loans, sustainable growth rate doesn't consider it.
As mentioned earlier, a sustainable growth rate is vital for every company. This is because the sustainable growth rate of your company tells you what stage of the company life cycle your business is currently in. Asides from this, it also helps in business planning and forecasting for long-term growth.
Have you ever heard the saying, “Whosoever fails to plan plans to fail?” Well, you should know that this saying aptly describes the importance of a sustainable growth rate to a company’s future growth, especially if the company plans for high growth.
Company growth should be progressive from one level to another. However, not all businesses are in optimal "shape" to experience long-term growth and company retention rates.
A sustainable growth rate makes it pretty easy to tell if your company is perfectly positioned for long-term success. At this point, it's possible to calculate the sustainable growth rate of your business.
In fact, not only is it possible, but it’s also recommended you do so. Knowing the sustainable growth rate of your company will help you set better strategic goals guaranteed to improve cash flow projections and capital acquisitions.
To calculate the sustainable growth rate of your company, you’ll need to multiply the retention rate by its return on equity. This formula is as follows:
Sustainable growth rate = Retention ratio x Return on equity
= (Net income/Total equity) x (1 - Dividend payout ratio)
It looks complex. Well, you should know that the sustainable growth rate formula is pretty straightforward to apply, provided you know what each term in the formula means. The guide below will describe extensively on each.
Your company's net income is simply the amount of cash inflow your company retains after subtracting taxes and deductions. The formula for calculating the net income of your company is as follows:
Net income = Total Revenues - Total Expenses
There are two primary sources of the total equity of long-term capital for businesses and companies. They are debts and equities.
The total equity of your company is the total amount of external financing from investors in exchange for a specific amount of company stock. It also includes all your company’s subsequent earnings.
To calculate your company’s total equity, use the formula below:
Total equity = Total assets - Total Liabilities
Remember how the definition of total equity is money “paid” to your company by investors in return for company shares? The dividend payout ratio refers to the money you pay these shareholders as dividends.
These dividends are paid from your company’s net income. The amount of money paid to a shareholder is a function of the number or percentage of shares held by the shareholder.
Think of it as a reward and return on investment for providing your company with the much-needed alternative to taking investment banking loans and incurring operational debts.
To calculate the dividend payout ratio of your company, use the formula;
Payout ratio = (Total Dividends/ Net Income) x 100
You will first need to derive the values of each formula component independently. Once you’ve done this, you can then apply the formula to calculate the sustainable growth rate of your company.
For practical examples, suppose a company has a net income of $200,000 and a total equity of $1,000,000. This same company also has a dividend payout ratio of 60%. What is the sustainable growth rate of this company?
Since the values of all the sustainable growth rate calculator formulas are already known, we’ll substitute these values into the formula.
Sustainable growth rate = ($200,000/$1,000,000) x (1 - 0.6)
= 0.2 x 0.4
= 8%
This “8%” means that the company being considered will only be able to sustain an 8% yearly growth rate without recording an increase in debt or any additional debt profile.
According to Havard Business Review, a company with a reasonable growth rate has a sustainable growth rate value that falls between 10% and 25% yearly. Anything less or more is concerning, as it indicates the company will soon run into growth and scalability issues.
A sustainable growth rate is a very effective way to evaluate and forecast the maximum growth rate.
For example, it follows the assumption that business owners re-invest all the company’s profits into the business, but this isn’t the case. Also, the sustainable growth rate formula fails to account for the impact of external factors like economic conditions and global economics on business health. Nevertheless, with proper planning and strategic goals, a company can achieve sustainable growth and financial leverage in the long term and ensure that they have retained earnings and enough capital.
So if you’re a business owner or financial analyst for a startup, you should use the sustainable growth rate formula to evaluate your company.
