Sustainable Growth Rate
IntermediateThe sustainable growth rate is the maximum rate at which a company can grow its sales and earnings using only its own retained profits, without issuing new shares or changing its level of debt relative to equity.
A company can fund growth from retained earnings, new borrowing or new equity. The sustainable growth rate asks how fast it can grow if it relies only on the first, while keeping its financial structure unchanged.
It is commonly estimated by multiplying return on equity by the retention ratio. For example, a company with an ROE of 12% that retains 60% of its profits has a sustainable growth rate of about 7.2% a year.
The logic is that retained profits increase equity, and keeping the debt-to-equity ratio constant allows a proportional increase in borrowing. Together, these fund growth in assets and sales.
If a company wants to grow faster than its sustainable growth rate, it must change something: improve profitability, retain more profit, borrow more relative to its equity or raise new equity. Growing faster without such changes can lead to cash shortages.
The measure is a simplified planning tool. It assumes a constant ROE, dividend policy and capital structure, which may not hold in practice, but it is useful for checking whether a company's growth plans are financially realistic.
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