Financial Matters - Adam Lean

Financial Matters - Adam Lean
Picture of Adam Lean Adam Lean has served as an accountant, small business owner, writer and consultant. Adam enjoys interacting with entrepreneurs and helping them grow their businesses. He writes on topics of interest to small business owners including business finances, technology in business, and digital marketing.

How to calculate your Sustainable Growth Rate (and why)

How to calculate your Sustainable Growth Rate (and why)

A top goal of most small business owners is to grow sales. More sales help lead to greater profit and a more robust business. Naturally, in most cases, the more sales you take on the more costs you will have to incur. These extra costs can be in the form of more employees to handle the larger volume or the extra warehouse space you may need, for example. How do you know how much you can grow without having to take on additional expenses or debt? In other words, all else being equal, how much can your sales grow with your existing financial infrastructure?

There is a formula that can help you with this. It is called the “Sustainable Growth Rate”. It tells you, in the form of a percentage, how much you can grow your sales without securing additional financing.

There are several reasons why the Sustainable Growth Rate is important to know for your business. You want to maximize your existing capacity before having to take on additional debt. Also, if your business grows too quickly you may run the risk of having to make hasty decisions such as taking on debt too quickly or giving away coveted equity.

There are many ways to calculate the Sustainable Growth Rate but we will focus on one particular method. Before we look at the formula, you will want to gather the following data on your business so that you can easily insert it in the formula.

  1. Net Profit Margin
    This is your net income after taxes (less any dividends paid out) divided by sales.
  2. Debt Ratio
    This is your total Liabilities divided by total Assets.
  3. Equity Ratio
    This is your total Equity divided by total Assets. (If you add B & C, it should equal 100%).
  4. Variable Asset %
    This is the percentage of assets (e.g. inventory) that is variable. (Increases directly with increased sales).

The Sustainable Growth Rate formula is: [A * (1 + B/C)] / [D - (A * (1 + B/C))]

Here is an example:

  1. Net Profit Margin = 10%
  2. Debt Ratio = 50%
  3. Equity Ratio = 50% (Notice that B & C equal 100%)
  4. Variable Asset % = 90%

The formula would be: [.10 * (1 + .50/.50)] / [.90 - (.10 * (1 + .50/.50))] = 28.6%. This means that your Sustainable Growth Rate is 28.6%. In other words, you can grow your sales by 28.6% without having to take on any additional financing.

If you would like to grow more than your Sustainable Growth Rate you will need to impact at least one of the pieces of data in the formula:

  1. Net Profit Margin
    You will need to either reduce expenses, raise prices and/or reduce any dividends paid out to yourself or to investors and use the additional money to handle the growth.
  2. Debt Ratio
    Increase debt by taking out a loan to get additional financing to handle the growth.
  3. Equity Ratio
    Acquire an equity investment in your business to get additional financing to handle the growth.
  4. Variable Asset %
    Become more efficient operationally by using more of your existing assets to produce sales. This would reduce your Variable Assets %.

Using the example above, let’s say we take out a loan which will increase our debt and impact our Debt Ratio (B) from 50% to 66%. This would also mean that the Equity Ratio would go down to 33% (it must equal 100%). Everything else remains the same.

Our new Sustainable Growth Rate would be: [.10 * (1 + .66/.33)] / [.90 - (.10 * (1 + .66/.33))] = 50%. This means that by taking on additional debt the business can grow an additional 21.4% (from 28.6% to 50.0%).

By calculating your Sustainable Growth Rate on a regular basis you will be able to maximize your sales using your existing assets and plan your strategy for any future sales growth.


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