In simple terms and with reference to a business, sustainable growth is the realistically attainable growth that a company could maintain without running into problems.
A business that grows too quickly may find it difficult to fund the growth. A business that grows too slowly or not at all may stagnate. Finding the optimum growth rate is the goal. A sustainable growth rate (SGR) is the maximum growth rate that a company can sustain without having to increase financial leverage. In essence, finding a company’s sustainable growth rate answers the question: how much can this company grow before it must borrow money? The models used to calculate sustainable growth assume that the business wants to: 1) maintain a target capital structure without issuing new equity; 2) maintain a target dividend payment ratio; and 3) increase sales as rapidly as market conditions allow. Since the asset to beginning of period equity ratio is constant and the firm’s only source of new equity is retained earnings, sales and assets cannot grow any faster than the retained earnings plus the additional debt that the retained earnings can support. The sustainable growth rate is consistent with the observed evidence that most corporations are reluctant to issue new equity. If, however, the firm is willing to issue additional equity, there is in principle no financial constraint on its growth rate. Indeed, the sustainable growth rate formula is directly predicated on return on equity.
To calculate the sustainable growth rate for a company, one must know how profitable the company is based on a measure of its return on equity (ROE). One must also know what percentage of a company’s earnings per share it pays out in dividends, which is called the dividend-payout ratio. With these figures one can multiply the company’s ROE by its plowback ratio, which is equal to 1 minus the dividend-payout ratio. [Sustainable growth rate = ROE x (1 – dividend-payout ratio). Just as the break-even point for a business is the ‘floor’ for minimum sales required to cover operating expenses, the SGR is an estimate of the ‘ceiling’ for maximum sales growth that can be achieved without exhausting operating cash flows. The SGR can be thought of as a growth break-even point.
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The Challenge Of Attaining Sustainable Growth
Creation of sustainable growth is a prime concern of small business owners and big corporate executives alike.
Obviously, however, achieving this goal is no easy task, given rapidly changing political, economic, competitive, and consumer trends. Each of these trends presents unique challenges to business leaders searching for the elusive grail of sustainable growth. Customer expectations, for example, have changed considerably over the last few generations. Modern consumers have less disposable wealth than their parents, which makes them more discriminating buyers. This fact, coupled with the legacy of a decade of quality and cost reduction programs, means that companies must try to attract customers by redefining value and keep those customers by beating their competitors in enhancing value. Similarly, competition is keen in nearly all industries, which have seen unprecedented breakdowns in the barriers that formerly separated them.
The growth challenge is articulated differently by different companies and within different industries. For some, developing and launching new products and services to meet the evolving needs of their customers is the issue. For others, capitalizing on global opportunities is key. Some companies look to new business areas that will represent the next major thrust for their business. And for a few companies, all of these strategic efforts are simultaneously used, along with ongoing efforts to rebuild organizational capabilities.
Economists and business researchers contend that achieving sustainable growth is not possible without paying heed to twin cornerstones: growth strategy and growth capability. Companies that pay inadequate attention to one aspect or the other are doomed to failure in their efforts to establish practices of sustainable growth (though short-term gains may be realized). After all, if a company has an excellent growth strategy in place, but has not put the necessary infrastructure in place to execute that strategy, long-term growth is impossible. The reverse is true as well.
Using The Sustainable Growth Rate
The concept of sustainable growth can be helpful for planning healthy corporate growth. This concept forces managers to consider the financial consequences of sales increases and to set sales growth goals that are consistent with the operating and financial policies of the firm.
Often, a conflict can arise if growth objectives are not consistent with the value of the organization’s sustainable growth.
According to economists, if a company’s sales expand at any rate other than the sustainable rate, one or more of the basic business ratios must change. If a company’s actual growth rate temporarily exceeds its sustainable rate, the required cash can likely be borrowed.
When actual growth exceeds sustainable growth for longer periods, management must formulate a financial strategy from among the following options: 1) sell new equity; 2) permanently increase financial leverage (i.e, take on more debt); 3) reduce dividends; 4) increase the profit margin; or 5) decrease the percentage of total assets to sales.
In practice, companies are often reluctant to undertake these measures. Firms dislike issuing equity because of high issue costs, possible dilution of earnings per share, and the unreliable nature of equity funding on terms favorable to the issuer. A firm can only increase financial leverage if there are assets that can be pledged and if its debt-to-equity ratio is reasonable in relation to its industry. The reduction of dividends typically has a negative impact on the company’s stock price. Companies can attempt to liquidate marginal operations, increase prices, or enhance manufacturing and distribution efficiencies to improve the profit margin. In addition, firms can source more activities from outside vendors or rent production facilities and equipment, which has the effect of improving the asset turnover ratio. Increasing the profit margin is difficult, however, and large sustainable increases may not be possible. Therefore, it is possible for a firm to grow too rapidly, which in turn can result in reduced liquidity and the unwanted depletion of financial resources.
The sustainable growth model is particularly helpful in situations in which a borrower requests additional financing. The need for additional loans creates a potentially risky situation of too much debt and too little equity. Either additional equity must be raised or the borrower will have to reduce the rate of expansion to a level that can be sustained without an increase in financial leverage.
Mature firms often have actual growth rates that are less than the sustainable growth rate. In these cases, management’s principal objective is finding productive uses for the cash flows that exist in excess of their needs.
Options available to business owners and executives in such cases include returning the money to shareholders through increased dividends or common stock repurchases, reducing the firm’s debt load, or increasing possession of lower earning liquid assets. Note that these actions serve to decrease the sustainable growth rate.
Alternatively, these firms can attempt to enhance their actual growth rates through the acquisition of rapidly growing companies.
Growth can come from two sources: increased volume and inflation. The inflationary increase in assets must be financed as though it were real growth.
Inflation increases the amount of external financing required and increases the debt-to-equity ratio when this ratio is measured on a historical cost basis. Thus, if creditors require that a firm’s historical debt-to-equity ratio stay constant, inflation lowers the firm’s sustainable growth rate.
See also: Financial Ratios