Sustainable Growth Rate

Sustainable growth rate (SGR) is the maximum growth rate that a company can achieve without raising any additional equity but with additional debt just enough to maintain its existing debt to equity ratio.

If a firm wants to grow its sales at sustainable level, it must growth in asset base such that it equals the sum of internally-generated equity (i.e. retained earnings) and an increase in debt which is barely enough to maintain its current debt to equity ratio. This can be written mathematically as follows:

Increase in Assets = Increase in Equity + Increase in Debt

Since internally-generated equity depends on its retention ratio and profit margin, and increase in debt depends on internally-generated equity and debt to equity ratio, sustainable growth rate is high when retention ratio is high (or equivalently dividend payout ratio is low), profit margin is high

Formula

Sustainable growth rate depends on return on equity (ROE) and retention ratio. The exact formula we can use depends on whether ROE is calculated using opening equity balance or closing equity balance.

When the opening retained earnings is used in calculation of ROE, sustainable growth rate can be calculated using the following formula:

Sustainable Growth Rate = ROE × Retention Ratio

However, if ROE is calculated by dividing net income by current year equity, we need to need an alternative formula:

Sustainable Growth Rate =ROE × Retention Ratio
1 − ROE × Retention Ratio

Since, net income divided by equity equals return on equity (ROE), we reach the formula for SGR:

Sustainable Growth Rate = ROE × (1 - Dividend Payout Ratio)

Sustainable Growth Rate from Profit Margin and D/E Ratio

Using DuPont analysis, we can break-down ROE into profit margin, asset turnover and equity multiplier, we can write sustainable growth rate as a function of profit margin P, financial leverage ratio A/E, asset turnover S/A and retention ratio RR as follows:

SGR = P × S/A × A/E × RR

SGR = P × S/A × (E+D)/E × RR

SGR = P × S/A × (1+D/E) × RR

Example

You have the following information about General Motors (GM) for FY 2016:

Total assets $221,690 million
Total liabilities $177,854 million
Net income for the period $9,427 million
Dividends paid $2,239 million

Calculate the company’s sustainable growth rate and work out the company’s new asset, liabilities, and equity level if the sustainable growth rate is achieved.

First, we need to find out return on equity and dividend payout ratio.

Return on Equity =$9,427 million= 21.51%
$221,690 million − 177,854 million

Next, let us work out the dividend payout ratio.

Dividend Payout Ratio =$2,239 million= 23.75%
$9,427 million

We have the ingredients to work out the sustainable growth rate:

Sustainable Growth Rate = 21.51% × (1 − 23.75%) = 16.40%

If the sustainable growth rate is achieved, the company’s new liabilities, equity and asset levels will be as follows:

Assets $258,042 = $221,690 × (1 + 16.40%)
Liabilities $207,018 = $177,854 × (1 + 16.40%)
Equity $51,024 = $43,866 × (1 + 16.40%)

The whole increase in equity will come from internal sources while the company may raise debt equal to $29,164 (=$207,018 − $177,854).

It is called sustainable growth rate because this can be achieved without burdening the company with too much debt relative to assets and equity.

Sustainable Growth Rate vs Internal Growth Rate

A company can expand its capacity and increase its sales by expanding its asset base. This increase can be funded by using its earnings or by raising external financing, i.e. issuing bonds or common stock. While using retained earnings there are two further options: (a) solely using the net income retained to fund assets and sales growth or (b) using the retained earnings while also allowing for additional borrowing such that the proportion between debt and equity in the company’s capital structure is maintained. The maximum growth rate in the first option is called internal growth rate while the growth rate that can be achieved using internal financing while maintaining capital mix, as in the second option, is called sustainable growth rate.

Written by Obaidullah Jan, ACA, CFA and last modified on

XPLAIND.com is a free educational website; of students, by students, and for students. You are welcome to learn a range of topics from accounting, economics, finance and more. We hope you like the work that has been done, and if you have any suggestions, your feedback is highly valuable. Let's connect!

Copyright © 2010-2019 XPLAIND.com