Companies who plan ahead and maintain sustainable growth rates will ultimately circumvent unprofitable growth. Thus by managing the growth rate, companies can avoid straining financial resources and overextending their financial leverage. Rapid growth and increased sales are dependent on financial resources. So, in order to improve sales in sustainable growth, a firm will need new assets, which can be financed through an increase in owners’ equity (retained earnings).
If a company plans to increase the SGR without issuing new equity or borrowing additional financial resources, then it should increase the profit margin, asset turnover ratio, assets to equity ratio, or retention rate. By using the return on equity and dividend payout ratio, the SGR then enables firms to forecast future equity and develop optimal growth rates.
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Calculate the sustainable growth rate using the following two equations.
SGR = (1-d) x ROE
SGR = PRAT
P is the Profit Margin (net profit divided by revenue). Whereas, R is the Retention Rate (1 minus the dividend payout ratio). And A is the Asset Turnover Ratio (sales revenue divided by total assets). Finally, T is the Assets-to-Equity Ratio (total assets divided by shareholders’ equity).
ROE = net income divided by shareholders’ equity = 100/400 = 25% or .25
SGR = (1-d) x ROE = (1-.4) x .25 = 15% or .15
From this example, the SGR works out to be 15%. First, calculate SGR by multiplying one minus the dividend-payout-ratio by the return on equity. A SGR of 15% indicates that the company can increase future earnings and sales up to 15% annually without having to borrow more funds or issue new equity. Learn other ways to increase the value (and cash flow) of your company by downloading the free 25 Ways to Improve Cash Flow whitepaper.
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