Sustainable Growth Rate (SGR)

What Is the Sustainable Growth Rate (SGR)?

The sustainable growth rate (SGR) is the maximum rate of growth that a company or social enterprise can support without funding growth with extra equity or debt. In other words, it is the rate at which the company can develop while utilizing its own internal revenue without borrowing from outside sources. The SGR involves augmenting sales and revenue growth without increasing financial leverage. Achieving the SGR can help a company prevent being over-leveraged and stay away from financial distress.

To start with, get or calculate the return on equity (ROE) of the company. ROE measures the profitability of a company by comparing net income to the company's shareholders' equity.

Then, deduct the company's dividend payout ratio from 1. The dividend payout ratio is the percentage of earnings per share paid to shareholders as dividends. At long last, multiply the difference by the ROE of the company.

Understanding Sustainable Growth Rates

The SGR of a company can help identify whether it's overseeing everyday operations properly, including paying its bills and getting paid on time. The rate is a long-term rate and is used to determine what stage a company is in. Overseeing accounts payable needs to be managed in a timely manner to keep cash flow running without a hitch.

For a company to operate above its SGR, it would need to maximize sales efforts and spotlight on high-edge products and services. Likewise, inventory management is important and management must have an understanding of the continuous inventory needed to match and support the company's sales level.

SGR Formula

Sustainable Growth Rate (SGR) = Retention Ratio x Return on Equity (ROE)

Overseeing Accounts Receivable

Dealing with the collection of accounts receivable is likewise critical to keeping up with cash flow and profit edges. Accounts receivable represents money owed by customers to the company. The longer it takes a company to collect its receivables contributes to a higher likelihood that it could have cash flow shortfalls and struggle to fund its operations properly. As a result, the company would need to cause extra debt or equity to make up for this cash flow shortfall. Companies with low SGR probably won't be dealing with their payables and receivables effectively.

High Sustainable Growth Rates

Supporting a high SGR in the long term can prove hard for most companies. As revenue increases, a company tends to reach a sales saturation point with its products. As a result, to keep up with the growth rate, companies need to expand into new or other products, which could have lower profit edges. The lower edges could decrease profitability, strain financial resources, and potentially lead to a need for new financing to support growth. Then again, companies that fail to achieve their SGR are at risk of stagnation.

The SGR calculation assumes that a company needs to keep a target capital structure of debt and equity, keep a static dividend payout ratio, and accelerate sales as fast as the organization allows.

There are cases when a company's growth becomes greater than whatever it can self-fund. In these cases, the firm must devise a financial strategy that raises the capital needed to fund its rapid growth. The company can issue equity, increase financial leverage through debt, reduce dividend payouts, or increase profit margins by expanding the efficiency of its revenue. These factors can increase the company's SGR.

The SGR of a company can likewise be used by lenders to determine whether the company is likely to be able to pay back its loans.

Sustainable Growth Rate versus PEG Ratio

The price-to-earnings-growth ratio (PEG ratio) is a stock's price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time frame period. The PEG ratio is used to determine a stock's value while considering the company's earnings growth. The PEG ratio is said to provide a more complete picture than the P/E ratio.

The SGR involves the growth rate of a company without considering the company's stock price while the PEG ratio calculates growth as it relates to the stock price. As a result, the SGR is a metric that evaluates the viability of growth as it relates to its debt and equity. The PEG ratio is a valuation metric used to determine in the event that the stock price is undervalued or overvalued.

Limitations of Using the SGR

Achieving the SGR is every company's goal, yet some headwinds can stop a business from developing and achieving its SGR.

Consumer trends and economic conditions can help a business achieve its sustainable growth or cause the firm to miss it completely. Consumers with less disposable income are customarily more conservative with spending, making them discriminating buyers. Companies compete for the business of these customers by cutting prices and potentially hindering growth. Companies likewise invest money into new product development to try to keep up with existing customers and develop market share, which can cut into a company's ability to develop and achieve its SGR.

A company's forecasting and business planning can detract from its ability to achieve sustainable growth in the long term. Companies sometimes confuse their growth strategy with growth capability and miscalculate their optimal SGR. On the off chance that long-term planning is poor, a company could achieve high growth in the short term yet will not support it in the long term.

In the long-term, companies need to reinvest in themselves through the purchase of fixed assets, which are property, plant, and equipment (PP&E). As a result, the company might need financing to fund its long-term growth through investment.

Capital-intensive industries like oil and gas need to use a combination of debt and equity financing to keep operating since their equipment, for example, oil drilling machines and oil rigs are so expensive.

It's important to compare a company's SGR with comparative companies in its industry to achieve a fair comparison and meaningful benchmark.

The Bottom Line

Companies need to keep steady over their growth rates, so the SGR is something that is calculated regularly. There might be a point where the rate is sustained at an elevated level however that stretches the company thin and may dip too far into their cash reserves. Right now, companies will typically consider outside financing.

Highlights

• Companies hoping to develop at a more substantial rate could cut their dividends, yet this is a contentious maneuver.
• A high SGR in the long-term can prove hard for companies due to competition entering the market, changes in economic conditions, and increased research and development.
• Companies with high SGRs are typically effective in expanding their sales efforts, zeroing in on high-edge products, and overseeing inventory, accounts payable, and accounts receivable.
• The sustainable growth rate (SGR) is the maximum rate of growth that a company can support without funding growth with extra equity or debt.
• The SGR is used by businesses to plan long-term growth, capital acquisitions, cash flow projections, and borrowing strategies.

FAQ

How Do You Calculate Sustainable Growth Rate?

You calculate the sustainable growth rate by taking the company's return on equity times the result of 1 minus the dividend payout ratio. Another method for working out it is to multiply the retention rate by the return on equity. The retention rate represents the percentage of earnings that the company has not paid out in dividends. It is the same formula, worded differently.

How Could a Company Increase Growth?

A company has various ways of increasing growth. A CEO could give a keynote speech that drives customers. The company could do a product rollout designed to maximize sales, or a company could increase growth by cutting costs like dividends or unprofitable divisions.

Why Is Sustainable Growth Rate Important?

The sustainable growth rate is an important measurement because it gives a company an accurate picture of expansion and equity requirements. Not all companies need to take on extra partners or outside financing, so the SGR allows the company to "toe the line" when it comes to growth utilizing their own revenues and capital.