
The sustainable growth rate (SGR) gauges how fast a business can expand without needing outside funding. It is based on the company’s earnings retention rate and return on equity. The earnings retention rate is the proportion of net income that is not paid out as dividends, while the return on equity is the ratio of net income to shareholders’ equity.In this article, we will delve What is the Sustainable Growth Rate Formula and How to Use It to aid businesses in their growth strategies. The SGR formula is:
SGR = Retention Rate x Return on Equity
Why is the SGR Formula Important?
The SGR formula can help managers and investors evaluate a company’s growth potential and financial health. A high SGR indicates that a company can grow rapidly by reinvesting its earnings into profitable projects without needing to borrow money or issue new shares. A low SGR suggests that a company has limited growth opportunities or faces financial constraints that prevent it from investing in its business.
The SGR formula can also help managers and investors compare a company’s actual growth rate with its sustainable growth rate. If the actual growth rate exceeds the SGR, it means that the company is growing faster than it can support with its internal resources, and may need to raise external capital or reduce its dividend payout. If the actual growth rate is lower than the SGR, it means that the company is not fully utilizing its earnings potential, and may have excess cash or inefficient investments.
How to Calculate the SGR Formula?
To calculate the SGR formula, we need to know the company’s retention rate and return on equity. The retention rate can be calculated by subtracting the dividend payout ratio from one: in other words, it is the percentage of earnings that are reinvested in the business. The portion of net income that is delivered as dividends to shareholders is known as the dividend payout ratio. Additionally, the return on equity can be calculated by dividing net income by average shareholders’ equity.
For example, suppose a company has a net income of $100 million, a dividend payout ratio of 20%, and an average shareholders’ equity of $500 million. The retention rate and return on equity are:
Retention Rate = 1 – Dividend Payout Ratio Retention Rate = 1 – 0.2 Retention Rate = 0.8
Return on Equity = Net Income / Average Shareholders’ Equity Return on Equity = $100 million / $500 million Return on Equity = 0.2
The SGR formula is:
SGR = Retention Rate x Return on Equity SGR = 0.8 x 0.2 SGR = 0.16
The SGR is 16%, which means that the company can grow at 16% per year without needing external financing, assuming that its capital structure and profitability remain constant.
Limitations of the SGR Formula
The SGR formula is a simple and useful tool for estimating a company’s growth potential, but it also has some limitations that should be considered:
- The sustainable growth rate formula assumes that the company’s capital structure, profitability, and dividend policy are constant over time, which may not be realistic in a dynamic business environment.
- The SGR formula does not account for external factors that may affect a company’s growth opportunities, such as market demand, competition, regulation, innovation, etc.
- The SGR formula overlooks investment quality and risk.
- Other factors besides the SGR formula determine optimal and sustainable growth.
Therefore, Use the SGR formula carefully and with other analyses.
Examples of the SGR Formula
To illustrate how the SGR formula works, let’s look at some examples of different companies and their sustainable growth rates.
Example 1: ABC Inc.
ABC Inc. is a profitable company that has a net income of $50 million, a dividend payout ratio of 30%, and an average shareholders’ equity of $200 million. The SGR formula for ABC Inc. is:
SGR = (1 – 0.3) x (50 / 200) SGR = 0.7 x 0.25 SGR = 0.175
- ABC Inc. has a 17.5% SGR. It can grow at this rate without external financing if it’s capital and profit stay constant: however, this is unlikely to happen in the long run.
Example 2: XYZ Ltd.
- XYZ Ltd. is a new company with $20 million in income, 10% dividends, and $100 million in equity: thus, it has a high return on equity ratio. The SGR formula for XYZ Ltd. is:
SGR = (1 – 0.1) x (20 / 100) SGR = 0.9 x 0.2 SGR = 0.18
XYZ Ltd. has an 18% SGR. It can grow at this rate without external financing if its capital and profit stay constant.
Example 3: PQR Co.
PQR Co. is an old company with $40 million in income, 50% dividends, and $300 million in equity. The SGR formula for PQR Co. is:
SGR = (1 – 0.5) x (40 / 300) SGR = 0.5 x 0.133 SGR = 0.067
PQR Co. has a 6.7% SGR. It can grow at this rate without external financing if it’s capital and profit stay constant
How to Use the SGR Formula for Business Planning
The SGR formula shows you how much your company can grow realistically. You can use the SGR formula to:
- Set realistic and achievable growth targets that align with your company’s financial capabilities and resources.
- Evaluate your company’s performance and compare it with your industry peers and competitors.
- Identify the factors that affect your company’s growth rate, such as profitability, capital structure, dividend policy, and investment opportunities.
- Determine the optimal mix of debt and equity financing for your company’s growth needs and risk profile.
- Assess the impact of different scenarios and decisions on your company’s growth rate and financial health.
Summary and Call to Action
The sustainable growth rate (SGR) is a measure of how much a company can grow without relying on external financing. It is based on the company’s earnings retention rate and return on equity. The SGR formula is:
SGR = Retention Rate x Return on Equity
The SGR formula shows your company’s growth potential and financial health. A high SGR means you can grow fast by using your earnings for profitable projects. A low SGR means you have few growth opportunities or financial challenges.
If you want to learn more about the SGR formula and how to use it for your business planning, you can download our free SGR calculator template. This template will help you calculate your company’s SGR and compare it with your actual growth rate. This template lets you test different scenarios and factors on your growth and finances.
Download our free SGR calculator template now and start planning your business growth with confidence!