What is the 'Sustainable Growth Rate - SGR'
The sustainable growth rate (SGR) is the maximum rate of growth that a firm can sustain without having to increase financial leverage or look for outside financing. The SGR is a measure of how large and how quickly a firm can grow without borrowing more money. After a firm has passed this rate, its growth will decline in the long term, and it must borrow funds to facilitate additional growth.
BREAKING DOWN 'Sustainable Growth Rate - SGR'
A company's SGR is the product of its return on equity (ROE) and the percentage of its profits that is plowed back into the firm. SGR is calculated as: ROE x (1 - dividend-payout ratio). The SGR calculation assumes that a company wants to maintain a target capital structure of debt and equity, keep a static dividend payout ratio, and accelerate sales as quickly as the organization allows.
If a company has a ROE of 15% and a payout ratio of 75%, for example, its SGR is calculated by taking 0.15 and multiplying it by (1 - 0.75), giving the company a SGR of 0.0375. This means that the company can safely grow at a rate of 3.75% using its own revenue and remain self-sustaining. If the company wants to accelerate its growth past this threshold to 4%, it needs to seek outside funding.
Barriers to the Attainment of Sustainable Growth
Achieving SGR is every company's goal, but some headwinds can stop a business from growing and achieving its optimal SGR.
Consumer trends can cause a business to achieve sustainable growth or miss it completely. Modern consumers have less disposable income and are traditionally more conservative with spending, making them discriminating buyers. Companies compete for the business of these customers by slashing prices and potentially decreasing growth. Companies also invest money into new product development to try to keep existing customers, which can cut into a company's ability to grow and achieve its SGR.
Another factor that detracts from a company's ability to achieve sustainable growth is in its planning ability. Many companies confuse growth strategy with growth capability and misidentify the optimal SGR. When this happens, a company can achieve high growth in the short term but won't sustain it in the long term.
When Growth Exceeds the SGR
There are cases when a company's growth becomes greater than what it can self-fund. In these cases, the company must devise a financial strategy that sells more equity, increases financial leverage through debt, reduces dividend payouts, increases profit margins or decreases the asset to sales ratio. Any of these factors can increase the SGR to a higher level.