• Finance ,
• 20 Oct

Sustainable Growth Rate is the max growth rate a firm can achieve without changing the capital structure. This is subtly different than the Internal Growth Rate. Sustainable growth rates do not include external equity financing, but can include increasing debt as long as the debt-equity remains the same. This happens when retained earnings increases equity which allows the debt-equity to remain constant with the increase in debt.

Sustainable Growth Rate

where

Internal Growth Rate

Return on Equity

Retention Rate

Sustainable Growth Rate

This is what we are solving for. If a company does not pay dividends, the Internal Growth rate is the company’s Return on Equity. Sustainable Growth Rate’s are higher than Internal Growth Rates as adding debt to finance your net income allows a greater ROE value.  If your company is not set up as a corporation, then the “owner draws” can be considered the same as dividends and substituted in this equation.

Return on Equity

The whole point of this ratio is to see how much the company can grow all by itself. This is important as an investor because you want the company to pay for itself.

Retention Rate

Some people refer to this as the Retention Ratio, or more often as the Plowback Ratio. This is the percentage of Retained Earnings the business keeps to help grow the business. The formula for this is explained in more detail in our Retention Rate Article.

Other Considerations

Don’t confuse a growth strategy with growth capacity. There are times when the potential growth of a company exceeds it’s capacity to fund itself. In this case you may want to seek out external capital through equity. A common example of this is pretty much every pitch you see on “The Shark Tank”.

Also understand opportunity cost of using money for one initiative vs another. If you need to expand product or services in order to reduce attrition or retain the current customers, this money cannot also be used to fund growth or R & D into new value added products.

Also, if you look this formula up in search engines, you may see alternative formulas. When deciding which one to use, we went with the formula used in a text book called, “Fundamentals of Corporate Finance” by Berk, DeMarzo, and Harford.