The object of most new startup businesses is to try and grow as fast as possible. As a business expands its revenue increases, and there is inevitably an increase in funding needed to finance additional assets, such as inventory and account receivable.
When producing financial projections careful consideration needs to be given to the impact this rate of growth has on the funding requirements of the business.
Of course the business could issue new equity to finance growth, but this has the downside of diluting the current shareholders and might not be available. The alternative is to fund the growth from an internal source of finance such as retained earnings.
Internal Source of Finance
When a business makes a profit it can either distribute that profit to shareholders by way of dividends, or keep the profit within the business in the form of retained earnings. The retained earnings becomes part of the equity of the business and is therefore an internal source of finance.
The problem with using this internal source of finance to fund the business is that it is limited by the level of growth of retained earnings. If the business is to rely on retained earnings to finance growth and not take on additional equity capital, it must ensure that its growth is sustainable.
Sustainable Growth Rate SGR
One method of calculating the growth rate which the business can sustain is to use the sustainable growth rate formula, which can be stated as follows:
This formula simply sets out that the sustainable growth rate depends on the level of profit retained by the business.
Level of profit is represented by the return on equity (ROE). The return on equity is the ratio of net income to the book value of the equity and is more fully discussed in out return on equity tutorial.
The amount of profit retained by the business is indicated in the formula by the earnings retention rate which is the percentage of the total profits kept within the business.
It should be noted that the use of this formula relies on two important assumptions.
- As the business grows and revenue increases, additional assets including working capital will be required. The formula assumes assets will grow at the same rate as the revenue.
- As the retained earnings increases, the equity increases, and it is assumed that lenders will be prepared the lend additional debt finance to maintain a constant financial leverage (debt to equity) ratio for the business.
By adopting these two assumptions the rate at which the equity of the business grows must be the same as the rate at which its revenue grows.
Sustainable Growth Rate Example
Suppose for example a business has a return on equity of 25% and pays out dividends to shareholders representing 20% of its profits. The sustainable growth rate (SGR) can be calculated as follows:
Return on equity = 25% Earnings retention rate = 1 - 20% = 80% Sustainable growth rate = Return on equity x Earnings retention rate Sustainable growth rate = 25% x 80% Sustainable growth rate = 20%
Under these conditions, if the revenue growth rate is 20% or less, then the business will be able to generate sufficient funding to grow the business. If the revenue growth rate is greater than 20%, then the business will need to seek additional equity or increase its financial leverage in order to raise sufficient finance to fund the growth.
Financial Projections and Sustainable Growth Rate
Using the sustainable growth rate calculation when producing financial projections is simply a matter of comparing the planned revenue growth to the sustainable growth, and then making the necessary adjustments to try and balance the finances of the business.
Suppose a startup business has plans for rapid growth and intends to try and increase its revenue by a 80% each year. The business wants to fund the growth without having to introduce additional outside equity or changing its financial leverage, and therefore the retained earnings must be sufficient to increase the equity of the business at the same rate of 80%.
The financial projections show that the return on equity (ROE) of the business is currently 24% and that 25% of the profit is distributed to shareholders by way of dividend.
Step 1: Calculate the Sustainable Growth Rate
The first step is to calculate the equity or sustainable growth rate of the business using the SGR formula.
Return on equity = 24% Earnings retention rate = 1 - 25% = 75% Sustainable growth rate = Return on equity x Earnings retention rate Sustainable growth rate = 24% x 75% Sustainable growth rate = 18%
The calculation shows that the equity growth rate or sustainable growth rate is 18%.
Step 2: Compare the SGR with the Planned Growth Rate
Based on the current financial projections, the business can sustain an equity and therefore a revenue growth rate of 18%, compared to the planned growth rate of 80%. Clearly the business cannot expand at the planned rate without running out of funding.
Step 3: Make Corrective Adjustments
The business must now make adjustments to reduce the gap between the sustainable (18%) and planned growth rates (80%).
There are various alternatives available to the business to try and make corrections and balance its finances including the following:
Decrease the Planned Growth Rate
The business can simply decide to grow at a slower rate to ensure that it has the required internal resources to fund the growth. In this example the business should aim to grow at the rate of 18%.
Increase the Sustainable Growth Rate
The business can aim to increase the sustainable growth rate by improving the profitability and therefore the return on equity of the business, or by reducing the amount paid out as dividends.
For example, suppose the return on equity was increased to 45% by improving the profitability of business, and the business decided not to pay out any dividends while it was growing, then the sustainable growth rate equation would give the following result:
Return on equity = 45% Earnings retention rate = 1 - 0% = 100% Sustainable growth rate = Return on equity x Earnings retention rate Sustainable growth rate = 45% x 100% Sustainable growth rate = 45%
The equity growth rate and sustainable growth rate is now 45%. While not the planned 80% growth rate, it is a substantial improvement on the previous 18%, and the business can now grow more rapidly without resorting to external finance.
Use Additional External Finance
The sustainable growth rate calculation is based on financing the business from internal resources and keeping the financial leverage constant.
Ultimately, if the business wants to expand at a rate beyond its sustainable growth rate, to avoid running out of cash, it needs to seek additional external equity from investors or change its financial leverage and add more debt finance.
In the above example the planned growth rate was 80% and after adjustment the sustainable rate was improved from 18% to 45%, this still however leaves 35% (80% – 45%) which needs to be funded from external resources if the business wants to expand at the 80% rate.