As a business owner, it is important to have a solid understanding of what a sustainable growth rate (SGR) is and why it matters to the valuation of your company.
What is SGR?
A sustainable growth rate is the highest rate of revenue growth that a business can keep going without having to assume more debt or be more financially leveraged. SGR can show at what point a company has reached as far as maturation, which is critical for strategic and competitive business planning moving forward. In mathematical terms, SGR is the value the company can generate with the amount of money it retains. A very high growth rate can signify that a company is growing quickly. Reaching a high SGR can help a company avoid overextending, which means it can prevent financial burden. Additionally, creditors use the sustainable growth rate to determine whether a business could default on its loans. While a high SGR can be a good thing, it can also mean that a company is investing heavily in research and development, which can slow any debt repayment.
How Do You Calculate SGR?
The SGR formula is frequently used when valuating companies using valuation models such as the dividend discount model (DDM) or the discounted cash flow (DCF) model. You can arrive at an SGR after doing three calculations:
- Retention Ratio
This is the number of earnings the business retains after paying out dividends. It is calculated using the formula:
One minus (-) dividends paid divided by (÷) net income.
- Return on equity (ROE)
Net income divided by (÷) shareholders’ equity.
- Sustainable Growth Rate (SGR)
Retention ratio multiplied (x) by ROE.
By calculating an SGR, you can understand the rate at which your business can grow safely using its existing resources and revenue without taking on more debt for growth.
An SGR is different from an internal growth rate (IGR). An SGR is how much a business can grow using debt financing and the same capital structure. An internal growth rate is how much a company can grow with ZERO external financing and only by reinvesting its earnings.
Is it Difficult to Maintain an SGR?
Because of various mitigating factors, it is not necessarily easy to maintain a high SGR in the long term. You have to contend with new competitors, economic impacts, changing consumer trends, and the need to conduct research and development to keep up with all these factors. Competing for customers can sometimes force you to lower your prices, which slows growth. And while investing in research and development can eventually (and ideally) result in market share growth, the effort inhibits the SGR. Companies that maintain high SGRs are usually successful at maximizing sales efforts to focus on high-margin products while effectively managing inventory, accounts payable, and receivable. Companies that do not attain high SGR risk falling flat and not doing enough to sustain a profitable business.
We just mentioned how inventory management is key to sustaining a high SGR. This is because management must understand how much ongoing inventory is needed in order to match the company’s degree of sales.
Maintaining a high SGR also means that it is important to properly manage accounts receivable to understand cash flow and profit margins. Accounts receivable shows all the money that is owed to the company. When it takes a long time to collect that money, cash flow is low, and the ability to pay for business operations is suboptimal. And that usually means that the business needs to assume more debt to keep the day-to-day operations up and running.
What Else You Should Know About SGR
It is important to understand how growth can result from increased volume and inflation. An increase in inflation means that assets should be financed as if they were true growth. This is because inflation raises the amount of outside financing required and raises the debt/equity ratio when calculated on a historical cost basis. If creditors require a company’s historical debt/equity ratio to remain constant, inflation lowers the company’s SGR.
A business can see growth more quickly than it was prepared to fund. This is why you should be prepared to devise a financial strategy to raise capital to support rapid growth if it happens to your company. For example, you can optimize your use of revenue by issuing equity, assuming debt, lowering dividend payouts, or raising profit margins.
Sometimes business owners mix up growth strategy with growth capability, but they are not the same. You need to plan for the long term. While you may attain high growth quickly, it is unlikely that you will be able to sustain it.
No “one number” or even a range means an SGR is good or bad. Still, a common way to determine if an SGR is favorable is to compare it to its home country’s GDP growth rate. If the SGR is higher than the GDP growth rate, the company is outperforming the economy, which is a good thing.
How Does SGR Affect Valuations?
Your SGR can be a significant factor in the valuation of your company because it indicates several essential things about the business’s health and working capital, especially if your company is in the lower middle market. For example, it can identify whether the business is being properly managed regarding day-to-day operations, whether the bills are being paid on time, and if accounts payable are being managed effectively to keep cash flow running smoothly. The higher the company’s SGR, the greater its potential upside.