Sustainable Growth for a Business
It's important to grow your business carefully
Businesses see growth as a good thing. The more and the faster a business can grow, the better, right? Not necessarily. In order for a business to grow and not run into problems with financing, it has to grow at a sustainable growth rate. Businesses have to be able to finance their growth with either debt or equity financing. If they do not have enough financing but have runaway growth, they may find it difficult to get financing to sustain that growth. On the other hand, a business that grows too slowly will stagnate.
Defining a Sustainable Growth Rate
The sustainable growth rate in a business is the maximum growth rate a business can achieve without having to increase its financial leverage or debt financing. Stated another way, it is the maximum growth rate that can be achieved given the company's profitability, asset utilization, dividend payout and debt ratios.
How a Sustainable Growth Rate Is Used in Small Business
You already know that the breakeven point is the "floor" for your sales growth. That is the absolute minimum in sales you need to make in order to stay in business. Think of the sustainable growth rate as the "ceiling" for your sales growth. It is the most your sales can grow without new financing and without exhausting your cash flow.
Growth Capability and Growth Strategy
Attaining the sustainable growth rate for your business is a little like searching for the holy grail. It's out there, but it is hard to find. You have to consider all the factors external to your business that interfere with your search, including political, economic, international and consumer trends. The environment in which you do business is very competitive for most businesses and most industries. You have to beat your competition by adding value in a different way to your product or service.
You need to address two primary issues: growth capability and growth strategy. Growth capability refers to your firm's infrastructure. Growth strategy refers to that business plan you need to have in place. Unless you have both of these issues covered, long-term growth will be impossible.
Using the Sustainable Growth Model
If you have your business plan and infrastructure in place and your firm is growing, you are in a good position. But what if your firm grows faster than you anticipate and actual growth exceeds sustainable growth? You aren't going to turn down sales, so how do you handle this situation?
You have several options. You can sell new equity in order to raise new money, raise more debt financing, permanently reduce dividend payments to shareholders, try to increase your profit margin or try to decrease your total asset turnover. Take note that all of these options will take time to put into place and work. There is also something wrong with all of these options.
Selling new equity dilutes the owner's shares. Raising more debt pushes the firm nearer to bankruptcy. Reducing dividends always makes shareholders unhappy. Increasing the profit and decreasing asset turnover are long-term strategies that are not as easy as they sound to implement. Mature firms often have sustainable growth rates somewhat less than their maximum rate. They distribute their excess cash to shareholders or put it to work in investments.
How to Calculate Sustainable Growth Rate
The formula for sustainable growth rate is:
SGR = Retention Ratio X Return on Equity
where: Retention Ratio = 1 - dividend payout ratio and Return on Equity = Net Income/Total Shareholder's Equity
The retention ratio is the flip side of the dividend payout ratio. If the firm pays out 20 percent of its earnings in dividends, then its retention ratio is 80 percent. The Return on Equity (ROE) is what the firm earns on the shareholder's investment in the firm. Multiply the two together, and you have the sustainable growth rate.