What Is a Sustainable Growth Rate?

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October 7, 2022

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What Is a Sustainable Growth Rate?

A sustainable growth rate is a measure of a company's growth in real terms. The rate potentially determines how much the company can grow without increasing costs while remaining profitable. To calculate a company's sustainable growth rate, divide the company's return on equity by its total assets. The dividend payout ratio and return on equity are two factors that may affect a company's overall sustainable growth rate.

What Is a Sustainable Growth Rate and How Is It Calculated?

The sustainable growth rate is the rate at which a company can grow and spend profits without having to invest any additional money. This rate is determined by the dividend payout ratio and the return on equity, which is the ratio between a company's net income and its shareholders' equity. The higher the return on equity, the higher the sustainable growth rate. 

Net income is the difference between a company's total earnings and operating costs. To calculate this ratio, you must divide the company's net income by its shareholders' equity. On the other hand, return on equity serves as an indicator of profitability. 

This ratio measures how profitable a company is, as well as the number of its profits that remain in the company. A company's return on equity can be calculated by dividing its net income by its average shareholders' equity balance.

The sustainable growth rate is a useful indicator to gauge a company's success. The rate allows an individual to assess a company's financial health and competitive strategy. In addition, it is an essential factor to consider when deciding whether or not to issue new debt or equity. 

What Are the Pros and Cons of Having a High Sustainable Growth Rate?

Investing in a company with a high sustainable growth rate could pay off. However, it can be challenging to maintain a high rate once the company is reaching the later stages of its life cycle. As a result, companies will need to use a combination of equity and debt financing to maintain a sustainable growth rate.

A high sustainable growth rate is a sign of operational competency. To calculate the sustainable growth rate of a company, first determine the return on equity and retention ratio. For example, if a company's return on equity is 20%, and its dividend is 30 %, then its sustainable growth rate is 0.14, which means it can grow at a maximum of 14% without external funding.

What’s more, a sustainable growth rate reflects an aggressive sales and inventory management strategy. In contrast, a low return on equity may be indicative of a poorly managed business. It can also be indicative of a company that is experiencing difficulty meeting sales targets. A company's sustainable growth rate is affected by economic conditions.

Why Is a Sustainable Growth Rate Important?

A sustainable growth rate provides a guideline for large corporations and small businesses to evaluate their capital needs. This is particularly helpful for a business that has outgrown its current cash flow. A high sustainable growth rate means that it is profitable and has strong internal growth potential. 

On the other hand, a low sustainable growth rate indicates the company is not meeting its financial targets. Companies with a low sustainable growth rate often need additional financing to continue to expand. Increasing the sustainable growth rate may help companies avoid taking on more debt and increase profits. However, it is crucial to consider the risks of rapid growth in order to mitigate risks

Calculating a company's sustainable growth is a significant financial metric. It lets investors know how much growth a company is capable of without outside funding. This ratio can be calculated by dividing its earnings by the percentage of retained earnings.

What Factors Potentially Affect the Sustainable Growth Rate?

The sustainable growth rate can be used as a benchmark to evaluate a company's financial performance, capital structure, and asset management. This helps the owners of a company set their financial strategy and growth objectives. Plus, it can be calculated using the retention rate of earnings and the dividend pay-out rate.

How Is the Dividend Pay-out Ratio Calculated?

To find the dividend pay-out ratio, divide the dividends by net income, excluding the impact of debt. The dividend pay-out ratio is a key component of the sustainable growth rate. Companies with high dividend pay-out ratios have a lower sustainable growth rate than companies with low dividend pay-out ratios.

What Is the Profitability Ratio?

In addition, the sustainable growth rate is affected by the company’s profitability ratio, which is a set of financial metrics. As the profitability ratio increases, the company has more internal funds to invest in growth. Firms with high dividend pay-out ratios may reach a saturation point with their product or service. 

As a result, they may have to expand into products with lower margins. Lower margins can reduce profitability and strain financial resources. Without a high sustainable growth rate, a company may face stagnation or even bankruptcy.

What Is Financial Leverage?

Another factor that impacts the sustainable growth rate is the use of financial leverage. Certain companies may be inclined to increase their leverage in order to maintain a high return on equity. But this can negatively affect a company's sustainable growth rate. This is why it is important to analyze the implications of the decision to issue new equity and debt.

When a company pays dividends, its profits are distributed to its shareholders. Dividends can help a company stay profitable, and they can increase the sustainability of the business. Moreover, businesses that pay dividends can be more efficient and take on more debt to finance their operations.

What Does the Sustainable Growth Rate Measure?

The sustainable growth rate is a measurement of a firm's ability to sustain its business operations. Derived from the growth rate of earnings and dividends, it is a key input into many valuation models. This ratio is required to calculate the terminal and continuing value of a firm.

Overall, the sustainable growth rate is a key metric that helps businesses of all sizes determine whether or not their strategy is sustainable. It also helps large companies determine if they have enough cash to sustain their growth. Dividend pay-out ratios are a good indicator of sustainable growth, as it shows how efficiently companies manage their inventory.

When looking at the sustainable growth rate, companies need to consider company-specific factors. For example, the ratio between return on equity and dividend pay-out is positive for high-growth companies, while negative for low-growth companies. 

This means that firms that have a high dividend pay-out ratio should reduce their pay-out ratio to achieve sustainable growth. Companies that have a low dividend pay-out ratio have more flexibility to build reserves.

Key Takeaways About the Sustainable Growth Rate and Return on Equity

Ultimately, the sustainable growth rate is a useful financial metric to understand how profitable a company is without using outside capital. This ratio is calculated by multiplying the company's return on equity by its business retention rate. A high sustainable growth rate is key to a company's ability to sustain growth without the need for external capital.

As a business grows, it is critical to modify its capital structure in order to achieve the highest sustainable growth rate. Using a sustainable growth rate can guide the financial planning and growth strategy of a company. 

Return on equity measures the profitability of a company by comparing its net income to the average shareholder's equity. A high return on equity means that a company is profitable, but a low return on equity could mean a business has trouble paying back its debts.

The return on equity and the firm's capital structure can influence a firm's sustainable growth rate. Though this may depend on the specific firm, the firm's size, and the level of its leverage.

What Is a Simple Way for an Individual To Achieve Sustainable Income?

When it comes to creating and maintaining a sustainable stream of income, industry-leading financial products like Compound Banc make this process accessible and straightforward. Compound Banc empowers the everyday individual to achieve financial freedom by providing tools and opportunities to invest in real estate, which is historically one of the most solid investments. 

Offering bonds backed by actual real estate assets, Compound Banc allows its community to begin investing even if they only have $10 to start. Bond investing through Compound Banc gives bondholders compounded returns at a seven percent annual percentage yield (APY). 

With no annual, maintenance, or processing fees, as well as the option to withdraw money at any time, Compound Banc lets individuals build a sustainable income. Join Compound Banc today.

Sources:

What are 'real terms'? Definition and meaning | Market Business News 

Dividend Payout Ratio: What It Is & How To Calculate It | Seeking Alpha 

Net Income | Investor

Debt Financing | Department of Energy 

Risk Mitigation | Ready 

Profitability Ratios - Calculate Margin, Profits, Return on Equity (ROE) | Corporate Finance Institute 

Bankruptcy Basics | United States Courts 

High-employment-growth firms: defining and counting them | BLS

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