Calculate the Sustainable Growth Rate

A sustainable growth rate is the rate a business can increase it's income without having to borrow more money from lenders or investors. As a small business owner, the rate represents how much more money you can take in each year without putting in more of your own money, or borrowing more from the bank. Small and big business owners alike should calculate their sustainable growth rates, and use them to determine whether they have adequate capital to meet their strategic growth needs.

Steps

Calculating the Sustainable Growth Rate

  1. Divide sales by total assets. This is the asset utilization rate - the number of sales you make each year as a percentage of your total assets.
    • Example: Total assets at year end - $100,000. Total sales throughout year - $25,000. Your asset utilization rate is $25,000/$100,000, or 25%, which means every year you produce about 25% of your assets in sales.
  2. Divide net income by total sales. This is the company's profitability rate, or the percentage of total sales that the business keeps at the end of the year after paying all of its expenses. (Net income is sales minus expenses.)
    • Example: Net Income - $5,000. Your profitability rate is $5,000/$25,000, or 20%, which means every year you keep about 20% of what you earn, and the rest pays for the cost of business.
  3. Divide total debt by total equity. This is the company's financial utilization rate.
    • Calculate total equity by subtracting total debt from total assets.
    • Example: Total Debt: 50,000. Total Equity: 50,000. Financial utilization is 100%.
  4. Multiply the asset utilization, profitability, and financial utilization rates. Take the three percentages you just calculated and multiply them together. This is the business’ return on equity (ROE). The ROE is the amount of the company’s profits that it keeps for itself, and can use to generate future profits.[1]
    • Example: multiply the three rates together - 25% x 20% x 100% - to calculate the ROE of 5%.
  5. Divide net income by total dividends. This is the dividend rate, which is the percentage of your earnings you give back to shareholders. (If you own a small business, anything you take out for yourself at year end, in addition to your salary, is a dividend.)
    • Example: Net Income: $5,000. Dividends: $500. $500/$5,000 = 10% dividend rate.
  6. Subtract the dividend rate from 100%. This is the business' retention ratio, or the percentage of net income the business keeps for itself after it pays dividends.
    • Example: 100% - 10% = 90% business retention rate.
    • The business retention ratio is important because it factors into the sustainable growth rate any amount you will be paying in dividends, and assumes that you will continue to pay dividends at that rate in the future.
  7. Multiply the earnings retention rate and the ROE. This is the sustainable growth rate. This figure represents the return on your business investment you can achieve without issuing new stock, investing additional personal funds into equity, borrowing more debt, or increasing your profit margins.[1]
    • Example: multiply the calculated ROE by the retention rate - 5% x 90% - to calculate the final sustainable growth rate - 4.5%. This business can increase the earnings it turns back into equity by 4.5% year over year.

Applying the Sustainable Growth Rate

  1. Calculate your actual growth rate. The actual growth rate in a company is simply the increase in sales over a given period of time. Divide the sales figure from your starting point by your most recent sales figure. The actual growth rate should be calculated based on the same time period used to calculate the sustainable growth rate.
    • Your actual growth rate will vary by month, quarter, or whatever period you use to report financial results. Because actual growth rate is just the percentage change in your sales, it changes frequently.
    • When calculating the actual growth rate, take care that your sales figures represent the same amount of time each. If you compare your sales from the 4th quarter of the year to the 1st month of the year, your growth rate will appear much larger than it actually is. Ensure your are comparing apples to apples, or more specifically, weeks to weeks, months to months, quarters to quarters, years to years, and so on.
  2. Compare your actual and sustainable growth rate. Your business may be growing faster, slower, or just at the sustainable growth rate. While rapid growth might seem like a positive indicator, a growth rate that exceeds the sustainable growth rate means the business doesn’t have enough cash on hand to meet business needs at the rate the business is growing. If your calculated sustainable growth rate is higher than your return on equity, this may mean your business isn’t performing as well as it could.
    • As an example, imagine a construction company that builds houses. To start the company the owner invests $100,000, and he also borrows $100,000 from a bank to start the business. After a year of sales the business owner calculates his actual and sustainable growth rates, and notices his actual growth rate is much higher than his sustainable growth rate. As he has increases his sales, he needs additional funds to finance the costs of labor and materials to build additional houses in order to earn revenue. While these increase in sales may be good for business, the business owner won't be able to finance all of these costs without getting additional money from somewhere. By knowing the differences in growth rates, the owner can plan ahead for where he will secure additional funding, or whether he should slow company growth.
    • While a high actual growth rate isn’t by default a negative, it does mean the business will need to finance increases in operations by either issuing new stock, taking on new debt, reducing dividends, or increasing profit margins. Most new business owners prefer not to borrow more debt or issue more equity in the beginning years, and may need to slow growth to the sustainable growth rate.[2]
    • A lower actual growth rate than the calculated sustainable growth rate may serve as evidence that your business isn’t performing up to snuff.[2]
  3. Adjust your business. Use what you learned about your sustainable and actual growth rate to adjust your business plan. If you want to maintain a growth rate that is higher than your sustainable growth rate, you will need to pay for the growth in costs somehow, before you can reap the increased income. Consider borrowing, issuing additional equity, investing personal funds, or reducing dividends. If you don’t want to take any of these actions, slow your company growth to the sustainable growth rate so you will not need additional funds to finance your costs.[3]
    • If your actual growth rate is below your sustainable growth rate, you may have more assets on hand than you need to get the job done. If you aren’t planning on increasing your production, you may consider paying back some debt or issuing a dividend to stockholders.
  4. Maintain perspective. Remember that growth rates are calculations based on past performance, and cannot perfectly predict the future. Your actual and sustainable growth rates will probably never perfectly match, and you should use the rates as a tool to guide business decision making, not a metric to paralyze your decision making or stunt your business. The sustainable growth rate gains more and more meaning as time passes and your business becomes more reliable - in the first year, your actual and sustainable growth rates may fluctuate drastically, which is expected.

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Sources and Citations

  1. ↑ 1.0 1.1 http://www.studyfinance.com/lessons/sustaingrowth/?page=01
  2. ↑ 2.0 2.1 http://www.studyfinance.com/lessons/sustaingrowth/?page=04
  3. ↑ http://www.investinganswers.com/financial-dictionary/businesses-corporations/sustainable-growth-rate-1641
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