The sustainable growth rate (SGR) of a firm is the maximum rate of growth in sales that can be achieved, given the firm's profitability, asset utilization, and desired dividend payout and debt (financial leverage) ratios. Variables typically include the net profit margin on new and existing revenues; the asset turnover ratio, which is the ratio of sales revenues to total assets; the assets to beginning of period equity ratio; and the retention rate, which is defined as the fraction of earnings retained in the business.
Sustainable growth models 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. "Assuming asset growth broadly parallels sales growth, the SGR is calculated as the retained [return on equity], i.e. your company's [return on equity] minus the dividend payout percentage," wrote John Costa in Outlook. "Just as the break-even point is the 'floor' for minimum sales required to cover operating expenses, so the SGR is an estimate of the 'ceiling' for maximum sales growth that can be achieved without exhausting operating cash flows. Think of it as a growth break-even point."
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. Jayne Buxton and Mike Davidson pointed out in Strategy and Leadership that each of these trends present 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 will have to attract customers by redefining value based on unique customer insights and keep customers by beating their competitors in enhancing value," said Buxton and Davidson. Similarly, competition is keen in nearly all industries, which have seen unprecedented breakdowns in the barriers that formerly separated them. "Companies now must look widely afield to identify their competitors and their available option in the search for creating sustainable competitive advantage," they said.
In addition, Buxton and Davidson noted that "the growth challenge is articulated differently by different leaders. 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; for still others, the challenge is identifying the one new business that will represent the next major thrust for the company. And for a few, all of these strategic challenges are simultaneously top-of-mind, along with the enormous task of rebuilding 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 above-mentioned 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, the use of 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/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 including returning the money to shareholders through increased dividends or common stock repurchases, reducing the firm's debtload, 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 cost debt-to-equity ratio stay constant, inflation lowers the firm's sustainable growth rate.