The faster your business can grow—the better?
Not necessarily. In order for a business to grow without unnecessary financial and operational hurdles, it must develop at a rate which takes into consideration the consequences of increased sales volume and staff, while remaining consistant with the methodology that made the business possible. Calculating the sustainable growth rate for your business can help you plan for the future and reduce the danger of becoming over-leveraged.
Maximum Growth Rate
In order to define the sustainable growth rate for a particular business, shareholders must first identify the maximum growth rate their business can achieve without having to increase financial leverage or debt financing. Stated another way, it's the growth that can be achieved given the company's current profitability, asset utilization, dividend payout, and debt ratios.
Floor and Ceiling of Sales Growth
The breakeven point is the "floor" for your sales growth. This 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's the most your sales can grow without new financing and without exhausting your cash flow.
Growth Capability and Growth Strategy
Finding the sustainable growth rate for your business is complicated, as you must consider the external factors that could interfere with business growth, including political, economic, and consumer trends. If the environment in which you do business is highly saturated with competition, for example, you may have to create additional value through your product or service in order to grow within the market.
You will also need to address two primary issues: growth capability and growth strategy. Growth capability refers to your firm's infrastructure: computers, office space, and personnel. Is there room to grow your sales without adding additional infrastructure? Growth strategy refers to the comprehensiveness of your business plan. Unless you have both of these goals understood and documented, long-term growth will be elusive.
Sustainable Growth Model
You business is never going to turn down additional sales—so how do you handle more work, and while balancing greater demands from your clientele and your team?
You have several options:
- Sell equity in order to raise new money.
- Raise more debt financing.
- Reduce dividend payments to shareholders.
- Increase your profit margin.
- Decrease your total asset turnover.
Here are some challenges that go along with each option:
- 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 can take months or even years to overcome.
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.
Sustainable Growth Rate Calculation
The formula for a 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% of its earnings in dividends, then its retention ratio is 80%. 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.