The sustainable growth rate (SGR) is a growth rate that showcases the maximum growth a company can sustain without any extra equity or debt. SGR is the rate at which the earnings and dividends of any company can continue to grow forever. The embedded notion in the computation of sustainable growth rate is based on no additional debt or equity being issued, and the capital structure remains unchanged. It is the growth based only on earnings ploughed back in business. Thus, it is an indicator based on only the operational effectiveness of a business. SGR is fundamentally a relation between the current operations of any organisation and its future value.
To compute Sustainable Growth Rate (SGR) for an organisation, the following assumptions are considered–
Any organization meeting above criteria shall attain and uphold a high sustainable growth rate, being a positive sign of its operational ability.
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Sustainable growth rate (SGR) is a function of Return on Equity and Reinvestment rate of earnings or the Retention Rate. The Retention Rate is Net Income minus Dividends divided by Net Income, and Return on Equity is the Net Income upon Total Shareholder’s Equity.
Retention rate shows the earnings ploughed back in business, while Return on Equity (ROE) is what investors realised relative to profits generated by a company.
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B = retention ratio
ROE = Return on Equity
Company ‘Super’ has a 15% return on equity and its’ dividend payout ratio is 50% of earnings. So it’s’ SGR (Sustainable Growth Rate) will be:
15% Return on equity x (1 – 0.50 Dividend payout ratio)
= 0.15 x 0.50
= 0.075 or 7.5% (SGR)
Meaning, ‘Super’ can grow at a sustained rate of 7.5% per annum. To achieve any growth above 7.5%, ‘Super’ would need outside financing in the form of Debt or Equity.
SGR tends to drop over time as an initial market of a product becomes saturated, profitability is reduced. As the firm grows in complexity and size, it incurs more overheads which cut its profits. Competitors also attack profitable firms by reducing prices, thus increasing pricing pressure and dropping profits. This consequently results in a reduced sustainable growth rate over time.
Sustainable Growth Rate identifies the following things:
A sustainable growth rate is essential because it informs analysts and investors about the organisation's maximum possible rate of growth. SGR can also be used to assess the life cycle stage at which the business is currently. Mature companies usually have a low SGR and can afford to pay a more significant portion of net income as dividends. Growing organisations have a high SGR as they generally cannot produce any bonuses or the payout is comparatively lesser.
It gives management estimation of the amount of external capital needed to achieve a predefined level of growth. It helps in managing debtors as a low SGR can force management to question the accounts receivables efficiency. This is because a tighter receivable position reduces earnings potential, in turn reducing SGR. Efficient management of accounts receivable can also remove the need for external financing. Other than this its helps management streamline financial objectives with regards to their economic potential and objectives. It also shows the management how well internal resources are being utilised. The management can thus take steps to identify and correct any hindrances to unlock the full potential.