A sustainable growth rate is the amount of growth that a business can achieve and maintain on an ongoing basis without having to borrow money. This is different from a maximum growth rate, which is based on how much growth the business can achieve by using any means to expand the operation and still manage to cover all its expenses. All types of companies that consistently earn a profit have a sustainable growth rate that helps management plan for the ongoing stability of the business.
In order to calculate the sustainable growth rate for a given company, it is important to first determine the return on equity, or ROE, that is generated by the firm. ROE is simply the amount of net income that is produced for an entire year, using the money that shareholders have invested in the firm.
Once the return on equity is calculated, it is also necessary to determine the dividend payout ratio. This figure represents how well the earnings for the period are supporting the payments of dividends that are made to investors. Also known as a dividend cover in the UK and several other countries around the world, the dividend payout ratio is calculated by earnings per share by the dividends per share.
By multiplying the ROE by the dividend cover, the business is able to determine how much money is needed to maintain the current rate of growth making use of all assets currently in its position. Knowing this figure can help companies create plans to make the most use of projected income levels for the next year, including what to do with any surplus that is not needed to maintain this sustainable growth rate. Those surplus funds can be invested in some type of interest-bearing account or venture, or utilized to improve the efficiency of some area of the company as it currently exists.
Knowing the sustainable growth rate also helps a business gauge when and how to seek loans or lines of credit when considering some sort of expansion project. By understanding what type of debt load can be assumed and handled responsibly during that interim period between the establishment of some new facility and the new operation beginning to generate profits, the business can avoid overextending itself, and thus remain financially strong. Assuming that the new facility does generate the income projected, the company can then take steps to calculate a new sustainable growth rate for the upcoming annual period, and possibly look into the prospect of more expansion in the future.
