What Is the Sustainable Growth Rate Formula? (With Steps)
By Indeed Editorial Team
Published May 31, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
For businesses to continue growing, sustainability is the key to success. Using sustainable growth formulas, companies can determine whether their rate of growth may continue by assessing the organization, its financial health, and the competition. Understanding how these important growth calculations work is key to anticipating the future activity of a company and determining the feasibility of future spending. In this article, we define the sustainable growth rate formula, explain why it's important, describe how to calculate sustainable growth rate, and provide helpful examples of sustainable growth rate calculations.
What is the sustainable growth rate formula?
The sustainable growth rate formula is a way of determining a company's maximum potential growth without factoring in any additional funding. This is a valuable metric when forecasting a business's potential success using its current assets. Below is a definition of sustainable growth rate and the formula you can use to calculate it:
Sustainable growth rate
A sustainable growth rate is the maximum rate of growth achievable without gaining additional financing through equity or debt. This is similar to the operational growth rate, except that it doesn't factor in debts or borrowed funds. The principle of the formula offers a method for businesses to predict their growth in the long term. Understanding its sustainable growth rate can help a company determine if it has sufficient resources or capital to reach its strategic objectives. This can help to maximize revenue growth and sales rates within their current financial opportunities.
Sustainable growth rate formula
The sustainable growth rate formula uses two fundamental components. They are return on equity and the retention rate. Return on equity means the percentage of a company's earnings in relation to the equity others invest in the business. Retention rate means the percentage of earnings an organization keeps for future use or growth. The formula for sustainable growth rate is as follows:
Sustainable growth rate = Return on equity x retention rate
High sustainable growth rates mean that a company succeeds in focusing on high-margin products and handles business functions such as accounts receivable, inventory, accounts payable, and maximizing its sale potential. While an organization can have a high standard growth rate, it can be challenging to maintain this growth. There is a variety of factors which can have an unwanted effect on the growth of a company, including insufficient research and development, new competitors, or economic changes.
Why is sustainable growth rate important?
Sustainable growth rates are important to businesses of all sizes, ages, and locations. This metric can indicate which stage of the business life-cycle the organization is in, and can help identify its risks and opportunities. Growth rates such as these can help small businesses determine what activity they can feasibly sustain without receiving additional loans or spending more funds of their own. It can also help bigger organizations determine whether they have sufficient capital to reach their financial objectives.
How to calculate sustainable growth rate
Calculating sustainable growth is simple and requires a few essential pieces of information. The metrics you require are the business's net income, equity, dividends per share, and earnings per share. Here are the steps you can take to calculate the sustainable growth rate for a business:
1. Calculate the return on equity
You can start calculating the sustainable growth rate by determining the return on equity. In business, equity is the investment stakeholders have in the company, and the return on equity represents the rate of return for the value of a business's equity. This assesses the business's profitability by comparing its net income to the equity of its shareholders. Here's the formula for calculating return on equity:
Return on equity = Net income / equity
In this formula, net income is the difference between total operating costs and earnings. To determine net income, you can review financial statements to establish the gross income for the period before adding together all expenses from that timeframe. Next, subtract the total expenses from the gross income to determine your net income.
2. Calculate the rate of retention
The next stage is to calculate the rate of retention. To do this, you can first calculate the dividend payout ratio. Below are instructions for each of the calculation stages:
Dividend payout ratio calculation
Before you can calculate the retention rate, you first require the dividend payout ratio. This figure is the percentage of earnings per share, which the company pays back to shareholders in the form of dividends. Below is the formula for calculating the dividend payout ratio:
Dividend payout ratio = Dividends per share / earnings per share
Retention rate calculation
Next, you can use this dividend to calculate the retention rate to continue calculating the sustainable growth rate. The retention rate is the rate of earnings which an organization can reinvest in the company without spending it or paying it out to stakeholders. Retention rate refers to the proportion of earnings a company keeps back to categorize as earnings. This is the formula for calculating retention rate:
Retention rate = 1 - dividend payout ratio
3. Finish the calculation
Now, you may use your two previous calculations to finish calculating the sustainable growth rate. You can do this by multiplying the retention rate by the return on equity. The result of this calculation is the sustainable growth rate. In formula form, this calculation looks like this:
Sustainable growth rate = Return on equity x retention rate
Examples of sustainable growth rate
Reviewing examples of sustainable growth rates in relation to hypothetical business scenarios can be helpful for understanding how a company's financial figures relate to the calculation and the implications of its results. Here are three different examples of calculations for finding sustainable growth rate:
Unknown dividend payout ratio for a hat shop
Here's an example of calculating the sustainable rate of growth for a hat shop:
Marta's woolen hat shop wants to find its sustainable growth rate before determining whether it can expand to add a scarf range. The shop's net income over the prior year was $650,000, and its shareholder equity was $1,800,000. The shop's accountant divides 650,000 by 1,800,000 to determine that it has a 0.36 or 36% return on equity.
Marta's accountant knows that there are two dividends per share, with $4 in earnings per share. Next, they find a dividend payout ratio of 0.5, resulting in a retention ratio of 0.5 once they subtract this amount from 1. In the next calculation stage, the accountant determines the sustainable growth rate by multiplying 36 by 0.5 to result in the number 18. Here, the accountant has calculated that Marta's hat shop's sustainable growth rate is 18%, which is a promisingly high rate of growth.
Known dividend payout ratio for a trading card store
Here's a sustainable growth rate calculation example for a trading card store:
Ricardo's Trading Cards seeks to find out its sustainable growth rate to decide if it's feasible to expand into selling board games. The net income for the company over the prior year was $1,500,000, with a shareholder equity of $16,000,000. The company's dividend payout retention ratio is 0.3.
Ricardo's accountant starts by dividing 1,500,000 by 16,000,000 to find a return on equity of 0.093, or 9.3%. They then find that the business's retention rate is 0.7 by subtracting their dividend payout retention rate of 0.3 from 1. The accountant then multiplies 0.7 by 9.3 to get 6.51, meaning that the sustainable growth rate for Ricardos Trading Cards is 6.51% which is relatively low.
Unknown dividend payout ratio for a hairdresser
Here's an example of calculating the sustainable growth rate for a hairdresser:
The hairdresser who owns Sam's Cutz wants to determine the sustainable growth rate of the business before deciding if it can expand to open a second location. The prior year's income was $850,000, and its shareholder equity was $2,000,000. Sam does her own accounting and divides 850,000 by 2,000,000 to determine that it has a 0.42 or 42% return on equity.
Sam knows that there are four dividends per share, with $5 in earnings per share. Then, Sam finds a dividend payout ratio of 0.8, resulting in a retention ratio of 0.2 once they subtract this amount from 1. Next, Sam determines the sustainable growth rate by multiplying 42 by 0.2 to result in the number 8.4. Sam has calculated that her hairdresser's sustainable growth rate is 8.4%, which is probably not high enough to afford a new location.
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