Understanding Your Sustainable Growth Rate
When you ask people what their goals are for their business, many times we get the answer of growing. While this is always exciting, it is important to remember that not all growth is equal and you need to ensure you are growing at the right pace. That's where the idea of a sustainable growth rate comes in. It is like finding the sweet spot where your business can grow without having to look for external financing. For businesses, knowing and understanding this rate is critical to building strategies that lead to long term viability and financial health.
What is a Sustainable Growth Rate?
The sustainable growth rate is a measure of how quickly a company can grow its revenues without having to borrow money or raise funds. It's a key metric because it balances ambitious growth targets with financial stability, ensuring that expansion doesn't compromise the business's foundational integrity.
How Do You Calculate Your Sustainable Growth Rate?
To calculate your sustainable growth rate you will need to look at two things, how much profit does your business make for every dollar of ownership (otherwise known as your Return on Equity or ROE) and how much of that profit you keep in the business versus giving out to the owners via distributions or dividends (known as your Dividend Payout Ratio). The sustainable growth rate formula is as follows:
Sustainable Growth Rate = ROE × (1 − Dividend Payout Ratio)
This formula tells you how much of your profits you're putting back into your business to help it grow.
Understanding the Components
Return on Equity (ROE): This ratio indicates how good your company uses shareholders' equity to generate profits. A higher ROE suggests more efficient use of equity.
Dividend Payout Ratio: This ratio shows what percentage of earnings are distributed to shareholders or owners as dividends and distributions. A lower payout ratio means more retained earnings are available to fuel growth.
How to Use Your Sustainable Growth Rate
Calculate Your Rate: Start by determining your current ROE and dividend payout ratio to calculate your sustainable growth rate. This gives you a baseline understanding of your potential growth rate without additional financing.
Assess Your Business Health: Make sure your business’s financials foundation is solid. High growth rates on paper means little if your cash flow is unstable or your debt levels are uncomfortably high.
Think About Reinvestment: Look at how effectively you're reinvesting earnings back into the business. Smart reinvestment can boost your growth rate.
Balance Growth and Profitability: Growing too fast can sometimes hurt your profitability. Balance is key.
Think About Your Dividends and Distributions: If you want to grow faster, you might need to keep more of your profits in the business instead of taking them out as dividends or distributions.
Tips for Using Your Sustainable Growth Rate
Industry Benchmarks: Compare your SGR with industry benchmarks to gauge your performance and growth potential relative to competitors.
Growth Opportunities: Keep an eye on the market for chances to grow that fit with your sustainable growth rate.
Risk Management: Incorporate risk management strategies to safeguard against the uncertainties of aggressive expansion. This includes diversifying product lines, markets, and revenue streams.
Plan Ahead: Use your sustainable growth rate as a guide to strategic planning and to set realistic targets that align with your business's financial capacity and market potential.
Understanding and leveraging your sustainable growth rate is more than a financial exercise; it's a roadmap for your business's growth. By aligning growth ambitions with financial realities, businesses begin a journey of sustainable expansion, ensuring stability, profitability, and resilience in the face of market challenges. Remember, sustainable growth is not just about expanding your business's footprint; it's about building a legacy that endures. For more on how we can help, follow the link to this form.