The sustainable growth rate is the maximum increase in sales that a business can achieve without having to support it with additional debt or equity financing. A prudent management team will target a sales level that is sustainable, so that the firm does not increase its leverage, thereby minimizing the risk of bankruptcy. When management wants to avoid taking on new financing, it can still grow sales by engaging in one or more of the following activities:
- Shift the mix of sales towards more profitable products, which generate more cash flow to support additional sales.
- Accelerate the turnover of receivables and/or inventory. Doing so minimizes the need for working capital financing, which would otherwise increase in concert with an expanded sales level.
- Minimize dividend payments. A large dividend payment can seriously impair the growth of a business, so investors should be willing to forego dividends to support unusually strong sales growth, at least in the short term.
The calculation of the sustainable growth rate is as follows:
For example, a firm has a 20% return on equity and a dividend payout ratio of 40%. Its sustainable growth rate is calculated as follows:
20% Return on equity x (1 – 0.40 Dividend payout ratio)
= 0.20 x 0.60
= 12% Sustainable growth rate
In the example, the firm can grow at a sustained rate of 12% per year. Any growth rate beyond that level will require outside financing.
In reality, the sustainable growth rate tends to drop over time, for several reasons. First, a business tends to sell increasingly less profitable products and services as it chases more revenue growth. Second, a firm tends to grow in complexity as it expands in size, so the additional corporate overhead cuts into its profits. And finally, competitors tend to attack unusually profitable firms by cutting prices, which increases pricing pressure and therefore drops profit levels. Consequently, businesses usually experience a sustainable growth rate that declines over time.