The concept of sustainable growth was originally developed by Robert C. Higgins. The sustainable growth rate (SGR) of a firm is the maximum rate of growth in sales that can be achieved, given the firm's profitability, asset utilization, and desired dividend payout and debt (financial leverage) ratios. The variables in the model include: (1) the net profit margin on new and existing revenues (P); (2) the asset turnover ratio, which is the ratio of sales revenues to total assets (A); (3) the assets to beginning of period equity ratio (T); and (4) the retention rate, which is defined as the fraction of earnings retained in the business (R).
To compute a firm's SGR, multiply the four variables together, or, in other words, the SGR = PRAT. Alternatively, the SGR equals the retention ratio times the return on beginning of period equity. An examination of the SGR equation indicates that the SGR increases when the profit margin increases, the assets to beginning of period equity increases, asset turnover increases, or the retention rate increases.
The sustainable growth model assumes that the firm wants to: (1) maintain a target capital structure without issuing new equity; (2) maintain a target dividend payment ratio; and (3) increase sales as rapidly as market conditions allow. Since the asset to beginning of period equity ratio is constant and the firm's only source of new equity is retained earnings, sales and assets cannot grow any faster than the retained earnings plus the additional debt that the retained earnings can support. The SGR is consistent with the observed evidence that most corporations are reluctant to issue new equity and instead rely on the reinvestment of earnings to finance growth. Over the last decade, the market value of shares extinguished through repurchase or acquisition for cash by American corporations far exceeded the value of shares issued. If, however, the firm is willing to issue additional equity, there is in principle, no financial constraint on its growth rate.
To compute a firm's SGR, multiply the four variables together, or, in other words, the SGR = PRAT. Alternatively, the SGR equals the retention ratio times the return on beginning of period equity. An examination of the SGR equation indicates that the SGR increases when the profit margin increases, the assets to beginning of period equity increases, asset turnover increases, or the retention rate increases.
The sustainable growth model assumes that the firm wants to: (1) maintain a target capital structure without issuing new equity; (2) maintain a target dividend payment ratio; and (3) increase sales as rapidly as market conditions allow. Since the asset to beginning of period equity ratio is constant and the firm's only source of new equity is retained earnings, sales and assets cannot grow any faster than the retained earnings plus the additional debt that the retained earnings can support. The SGR is consistent with the observed evidence that most corporations are reluctant to issue new equity and instead rely on the reinvestment of earnings to finance growth. Over the last decade, the market value of shares extinguished through repurchase or acquisition for cash by American corporations far exceeded the value of shares issued. If, however, the firm is willing to issue additional equity, there is in principle, no financial constraint on its growth rate.
USING THE SUSTAINABLE GROWTH RATE
The concept of sustainable growth can be helpful for planning healthy corporate growth. This concept forces managers to consider the financial consequences of sales increases and to set sales growth goals that are consistent with the operating and financial policies of the firm. Often, a conflict can arise if growth objectives are not consistent with the value of the organization's sustainable growth.
If a company' s sales expand at any rate other than the sustainable rate, one or some combination of the four ratios must change. If a company's actual growth rate temporarily exceeds its sustainable rate, the required cash can likely be borrowed. When actual growth exceeds sustainable growth for longer periods, management must formulate a financial strategy from among the following options: (1) sell new equity; (2) permanently increase financial leverage (i.e., the use of debt); (3) reduce dividends; (4) increase the profit margin; or (5) decrease the percentage of total assets to sales.
In practice, firms may be reluctant to undertake these measures. Firms are reluctant to issue equity because of high issue costs, possible dilution of earnings per share, and the unreliable nature of equity funding on terms favorable to the issuer. A firm can increase financial leverage only if it has unused debt capacity with assets that can be pledged and its debt\equity ratio is reasonable in relation to its industry. The reduction of dividends typically has a negative impact on the company's stock price. Companies can attempt to liquidate marginal operations, increase prices, or enhance manufacturing and distribution efficiencies to improve the profit margin. In addition, firms can outsource more activities from outside vendors or lease production facilities and equipment, which has the effect of improving the asset turnover ratio. Increasing the profit margin is difficult, however, and large sustainable increases may not be possible. Therefore, it is possible for a firm to grow too rapidly, resulting in reduced liquidity and the need to deplete financial resources.
The sustainable growth model is particularly helpful in the situation in which a borrower requests additional financing. The need for additional loans creates a potentially risky situation of too much debt and too little equity. Either additional equity must be raised or the borrower will have to reduce the rate of expansion to a level that can be sustained without an increase in financial leverage.
Mature firms often have actual growth rates that are less than the sustainable growth rate. In these cases, management's principal objective is finding productive uses for the cash flows in excess of their needs. Options are to return the money to shareholders through increased dividends or common stock repurchases, reduce debt, or increase lower-earning liquid assets. Note that these actions serve to decrease the sustainable growth rate. Alternatively, these firms can attempt to enhance their actual growth rates through the acquisition of rapidly growing companies.
Growth can come from two sources: increased volume and inflation. The inflationary increase in assets must be financed as though it were real growth. Inflation increases the amount of external financing required and increases the debt/equity ratio when this ratio is measured on a historical cost basis. Thus, if creditors require that a firm's historical cost debt\equity ratio stay constant, inflation lowers the firm's sustainable growth rate.
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