What Is the Sustainable Growth Rate (SGR)?

The sustainable growth rate (SGR) is the maximum rate of growth that a company or social enterprise can sustain without having to finance growth with additional equity or debt. In other words, it is the rate at which the company can grow while using its own internal revenue without borrowing from outside sources. The SGR involves maximizing sales and revenue growth without increasing financial leverage. Achieving the SGR can help a company prevent being over-leveraged and avoid financial distress.

First, obtain or calculate the return on equity (ROE) of the company. ROE measures the profitability of a company by comparing net income to the company's shareholders' equity.

Then, subtract the company's dividend payout ratio from 1. The dividend payout ratio is the percentage of earnings per share paid to shareholders as dividends. Finally, multiply the difference by the ROE of the company.

Understanding Sustainable Growth Rates

The SGR of a company can help identify whether it's managing day-to-day operations properly, including paying its bills and getting paid on time. The rate is a long-term rate and is used to determine what stage a company is in. Managing accounts payable needs to be managed in a timely manner to keep cash flow running smoothly.

For a company to operate above its SGR, it would need to maximize sales efforts and focus on high-margin products and services. Also, inventory management is important and management must have an understanding of the ongoing inventory needed to match and sustain the company's sales level.

Managing Accounts Receivable

Managing the collection of accounts receivable is also critical to maintaining cash flow and profit margins. Accounts receivable represents money owed by customers to the company. The longer it takes a company to collect its receivables contributes to a higher likelihood that it might have cash flow shortfalls and struggle to fund its operations properly. As a result, the company would need to incur additional debt or equity to make up for this cash flow shortfall. Companies with low SGR might not be managing their payables and receivables effectively.

High Sustainable Growth Rates

Sustaining a high SGR in the long term can prove difficult for most companies. As revenue increases, a company tends to reach a sales saturation point with its products. As a result, to maintain the growth rate, companies need to expand into new or other products, which might have lower profit margins. The lower margins could decrease profitability, strain financial resources, and potentially lead to a need for new financing to sustain growth. On the other hand, companies that fail to attain their SGR are at risk of stagnation.

The SGR calculation assumes that a company wants to maintain a target capital structure of debt and equity, maintain a static dividend payout ratio, and accelerate sales as quickly as the organization allows.

There are cases when a company's growth becomes greater than what it can self-fund. In these cases, the firm must devise a financial strategy that raises the capital needed to fund its rapid growth. The company can issue equity, increase financial leverage through debt, reduce dividend payouts, or increase profit margins by maximizing the efficiency of its revenue. All of these factors can increase the company's SGR.

Sustainable Growth Rate vs. PEG Ratio

The price-to-earnings-growth ratio (PEG ratio) is a stock's price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. The PEG ratio is used to determine a stock's value while taking the company's earnings growth into account. The PEG ratio is said to provide a more complete picture than the P/E ratio.

The SGR involves the growth rate of a company without taking into account the company's stock price while the PEG ratio calculates growth as it relates to the stock price. As a result, the SGR is a metric that evaluates the viability of growth as it relates to its debt and equity. The PEG ratio is a valuation metric used to determine if the stock price is undervalued or overvalued.

Limitations of Using the SGR

Achieving the SGR is every company's goal, but some headwinds can stop a business from growing and achieving its SGR.

Consumer trends and economic conditions can help a business achieve its sustainable growth or cause the firm to miss it completely. Consumers with less disposable income are traditionally more conservative with spending, making them discriminating buyers. Companies compete for the business of these customers by slashing prices and potentially hindering growth. Companies also invest money into new product development to try to maintain existing customers and grow market share, which can cut into a company's ability to grow and achieve its SGR.

A company's forecasting and business planning can detract from its ability to achieve sustainable growth in the long term. Companies sometimes confuse their growth strategy with growth capability and miscalculate their optimal SGR. If long-term planning is poor, a company might achieve high growth in the short term but won't sustain it in the long term.

In the long-term, companies need to reinvest in themselves through the purchase of fixed assets, which are property, plant, and equipment (PP&E). As a result, the company may need financing to fund its long-term growth through investment.

Capital-intensive industries like oil and gas need to use a combination of debt and equity financing in order to keep operating since their equipment such as oil drilling machines and oil rigs are so expensive. It's important to compare a company's SGR with similar companies in its industry to achieve a fair comparison and meaningful benchmark.

The Bottom Line

Companies need to stay on top of their growth rates, so the SGR is something that is calculated regularly. There may be a point where the rate is sustained at an elevated level but that stretches the company thin and may dip too far into their cash reserves. At this point, companies will typically consider outside financing.