Sustainable Growth Rate Formula

Sustainable Growth Rate Formula (Table of Contents)

Sustainable Growth Rate Formula
Examples of Sustainable Growth Rate Formula (With Excel Template)
Sustainable Growth Rate Formula Calculator

In very simple language, the sustainable growth rate is the maximum growth rate which company can achieve keeping their capital structure intact and can sustain it without any additional debt requirement or equity infusion. Basically, it is the growth rate which a company can foresee in its long term. This growth rate is important for both small business and large companies. For a small business, this is the growth rate which it can sustain without putting additional money from its pocket or from taking a loan. Similarly, large corporates can use their sustainable growth rates to find out if they have enough capital to fulfill their strategic goals or not.

This is also an indicator to see at what stage of its life cycle, a company is in. It also helps us in determining the chances of default by a company. Higher the growth rate, greater is the earnings volatility, higher the risk and chances of default. Efficient management will not increase their leverage and risk of default and will try to target the sales level which is sustainable for them.

The sustainable growth rate formula is calculated by multiplying the company’s retention rate of its earnings by its return on equity. The formula to calculate the sustainable growth rate is:

Sustainable Growth Rate = Return on Equity (ROE) * Retention Rate

If there is no direct information of ROE is provided, it can be calculated as:

ROE = Net Income / Equity

Retention rate is the rate of earnings which a company reinvest in its business. In other words, once all the dividend etc.is paid to shareholders, the left amount is the retention rate

Retention Rate = 1 – Dividend Payout Ratio

So,

Sustainable Growth Rate = Return on Equity (ROE) * ( 1 – Dividend Payout Ratio )

Examples of Sustainable Growth Rate Formula (With Excel Template)

Let’s take an examples to understand the calculation of the Sustainable Growth Rate formula in a better manner.

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You can download this Sustainable Growth Rate Formula Excel Template here – Sustainable Growth Rate Formula Excel Template

Sustainable Growth Rate Formula – Example #1

Consider a small scale listed company X’s which is a wholesale dealer of auto spare parts. Below is the snapshot of X’s financial details

So to find X’s sustainable growth rate, we need to find out ROE and retention rate.

Equity is calculated using the formula given below

Equity = Total Assets – Total Liabilities

Equity = 220 – 180
Equity = 40

ROE is calculated using the formula given below

ROE = Net Income / Equity

ROE = 9.5 / 40
ROE = 23.75%

Dividend Payout Ratio is calculated using the formula given below

Dividend Payout Ratio = Dividends Paid / Net Income

Dividend Payout Ratio = 2.6 / 9.5
Dividend Payout Ratio = 0.2737

Retention Rate is calculated using the formula given below

Retention Rate = 1 – Dividend Payout Ratio

Retention Rate = 1 – 0.2737
Retention Rate = 0.7263

Sustainable Growth Rate is calculated using the formula given below

Sustainable Growth Rate = Return on Equity (ROE) * Retention Rate

Sustainable Growth Rate = 23.75% * 0.7263
Sustainable Growth Rate = 17.25%

Sustainable Growth Rate Formula – Example #2

Now let see some practical example. I have taken General Motors as Target Company for which we need to calculate the sustainable growth rate. Below is the extract of their financial statements for 2018:

https://in.finance.yahoo.com/quote/GM/balance-sheet?p=GM

ROE is calculated using the formula given below

ROE = Net Income / Equity

ROE = $8,014,000 / $38,860,000
ROE = 20.62%

Retention Rate is calculated using the formula given below

Retention Rate = 1 – Dividend Payout Ratio

Retention Rate = 1 – 27.24%
Retention Rate = 0.7276

Sustainable Growth Rate is calculated using the formula given below

Sustainable Growth Rate = Return on Equity (ROE) * Retention Rate

Sustainable Growth Rate = 0.7276 * 20.62%
Sustainable Growth Rate = 15.01%

Explanation of the Sustainable Growth Rate Formula

Every business wants to grow and achieve new heights. So every company wants to achieve sustainable growth rate but there are some limitation and headwinds which can stop a business from growing and achieving its sustainable growth rate.

Any company which is expanding its operations need to invest in the growing business. So they need to put money is purchasing fixed assets like Plant, equipment etc. Because of which they need to fund that investment via external financing. So basically they have to fund their growth from outside resources and financing. Similarly, companies which are capital-intensive like oil and gas etc. they do not have any other choice but to use both debt and equity financing to keep running since their equipment etc. are quite expensive

Companies, sometimes to increase its growth and business indulge themselves in a price war. They keep on slashing their prices to acquire more customers. But that they do at the cost of their profitability and growth and this is not sustainable in long term. Same way, proper and apt business planning help businesses to achieve sustainable growth in the long-term. But if long-term planning is poor, there might be a period of high growth rate initially, but it cannot be sustained in long term.

Relevance and Uses of Sustainable Growth Rate Formula

Sustainable growth rate formula, as discussed above, assumes that a company wants to increase its sales and revenue by maintaining its target capital structure along with a stable dividend payout ratio. So to do that, companies can do the following measures:

Improve cash flow by shifting the mix of sales towards more profitable products
Improve the receivables and/or inventory turnover so that working capital improves
Reduce dividend payment and reinvest more money into the business.

For companies, it is really difficult to sustain a high growth rate in long term. There are several reasons for that, including competition entering the market, changes in economic conditions and the need to increase research and development.

In a nutshell, the sustainable growth rate is one of the key parameters which businesses need to analyze and take into consideration which making any strategic decisions and raising money from external sources. If the growth cannot be sustained and we are taking huge debt, it will expose us to a high probability of default.