Sustainable growth rate (SGR) and internal growth rate (IGR) are closely linked business growth concepts.
SGR is the growth rate that a business can sustain without external financing. While IGR is the growth that can be achieved with internal resources.
Let us discuss what are sustainable growth and internal growth rates and the key differences between them.
What is the Sustainable Growth Rate?
A sustainable growth rate (SGR) is the growth rate that a business can sustain without relying on debt or equity financing.
It simply means it is the growth that a business can sustain without using more debt or equity financing. Then, the only source of financing for the business will be internal resources.
It is the maximum growth rate that a business can achieve without relying on new external financings like debt or equity.
SGR is funded by the profits and retained earnings of the business. Thus, the business will take steps to grow net income and reinvest more if it wants to keep the growth rate.
On the flip side, the SGR shows how much growth a business can sustain within its internal resources. A business will require a different level of reinvestment at different business lifecycle stages.
How to Calculate the Sustainable Growth Rate?
The sustainable growth rate can be calculated with the following formula:
Sustainable Growth Rate = Return on Equity × Retention Rate
You can find the SGR of a business by following these steps.
The first step is to calculate the return on equity (ROE). It can be calculated by dividing the net income by the total shareholder’s equity.
ROE is the return generated by a business using equity resources.
The second step is to calculate the retention ratio. It is the net income minus the dividend amount divided by the net income of the business.
It can be simply calculated as one minus the dividend payout ratio of the business as well.
Once you have both these ratios, you can use the SGR formula and multiply them to find out the SGR of the business.
You should always use the current values of ROE and retention ratios for the same accounting periods. Usually, these are taken for one year.
Let us calculate the sustainable growth rate for a company ABC with the help of the following available data.
Net Income = $ 1,500,000 Shareholder’s Equity = $ 1.5 million
Dividends = $ 600,000
ROE = Net Income/Shareholder’s Equity
ROE = $ 1,500,000/15,000,000 = 0.1 or 10%
Retention Rate = (Net Income – Dividends)/Net Income
Retention Rate = ($ 1,500,000 – $ 600,000)/$ 1,500,000 = 0.60 or 60%
Sustainable Growth Rate = ROA × Retention Rate
Sustainable Growth Rate = 0.10 × 0.60 = 0.06 or 6%
Importance of the Internal Growth Rate
The SGR of a business is an indication of its internal efficiency. It shows how well a business is managing its internal resources including profits, cash, and capital financing.
When a business has a high SGR, it shows the company is growing quickly. It shows that the business is generating high sales and its operational efficiency is good.
However, it also shows that the business would need to reinvest most of its profits to sustain the growing business needs. That in turn will increase the retention rate and hence the SGR.
When a business faces low SGR, it shows that the business growth is stagnant. It also shows that the business is not reinvesting its profits for growth or not generating sufficient profits at all.
Managing working capital management and its cash flows are important to maintain the SGR of a business. It should improve its accounts receivable management if it does not want to rely on external financing.
The interpretation of the SGR requires careful attention. For example, a high SGR is desirable but difficult to sustain in the long term.
Lenders usually consider a high SGR risky. They consider the business is reinvesting most of its profits in research and development as well as reinvesting in growth projects.
Thus, making repayment of debts more difficult than for a business with moderate SGR.
What is Internal Growth Rate?
Internal growth rate (IGR) is the growth achieved by a business without relying on external financings like debt or equity.
It is the growth rate supported by utilizing the retained earnings of a business. Thus, the higher the net income and retained earnings the higher the IGR usually.
In simple words, it is the ability of a business to fund its growth without obtaining more debt or equity financing.
It is an important metric for startups particularly as it shows their ability to generate more sales using profits and retained earnings.
How to Calculate the Internal Growth Rate?
The formula to calculate the IGR is:
Internal Growth Rate = (ROA×R)/1−(ROA×R)
ROA = Return on Assets R= Retention Rate
You can calculate the IGR by following these simple steps.
The first step is to calculate the return on assets of the business. It is the net income divided by the total net assets of the business.
For net assets, you can use the year-end values of all assets.
The second step is to calculate the retention ratio. It is the net earnings minus the dividend amount divided by the net income of the business.
It is one minus the dividend payout ratio of the company.
The final step is simply using both these metrics in the IGR formula. You’ll divide the resulting figure of ROA * retention rate by one minus the denominator amount.
Let us calculate the internal growth rate of a business ABC using the following data.
Net Income = $ 700,000 Average Total Assets (Year-End) = $ 3,500,000
Dividends = $ 400,000
Return on Assets = Net Income/Average total Assets
Return on Assets = $700,000/$3,500,000 = 0.20 or 20%
Retention Ratio = Reinvesting income/Net Income
Retention Ratio = ($700,000 – $400,000)/$700,000 = 0.42 0r 42%
Now we can use these two figures to calculate the IGR of ABC company for the year.
Internal Growth Rate = (ROA ×R)/1- (ROA×R)
Internal Growth Rate = (0.20 × 0.42)/1- (0.20× 0.42)
Internal Growth Rate = 0.084/0.916 = 0.0917 0r 9.17%
Importance of the Internal Growth Rate
The internal growth rate of a business shows how well it is supporting its core operations with its internal funding.
It is an indicator of the operational efficiency of the business. When a business generates more sales using its resources efficiently, it shows a higher IGR.
The IGR of a business also gives an idea of how much a business retains and reinvests its profits into positive NPV projects.
Investors can get an idea of how much they’ll need if they are going to expand further or beyond the IGR.
It is also directly linked to the dividend decision of the company. If the dividend payout ratio of the company increases, its retention ratio decreases. That in turn will decrease the IGR of the company.
In practice, it is often challenging for growing businesses to sustain their growth rates without relying on debt financing.
Sustainable Growth Rate Vs Internal Growth Rate – Key Differences
SGR is the maximum growth rate that a business can sustain without deploying external financing.
IGR is the growth rate produced by a business without using external financing.
SGR needs to be sustained once achieved while IGR is the growth that can be achieved without relying on external financing.
SGR indicates the growth stage of a business in its lifecycle. Also, it shows at what rate a business can grow using its internal resources.
IGR shows the operational efficiency of a business. It shows how much a business can generate in terms of sales and net income with its available resources.
Achieving the highest possible growth rate is easier than sustaining it in the long run. Therefore, SGR does not offer a comprehensive analysis of business growth.
Also, SGR depends on several external factors like consumer trends, economic conditions, inflation rates, interest rates, and so on.
IGR focuses on utilizing retained earnings. It means the business would reinvest most of its profits without distributing dividends.
Thus, IGR is suitable for growing businesses in the early stages but not for established businesses where shareholders expect large dividends.
Again, IGR can be affected by several external factors as well.
SGR helps a business:
- Forecast its capital financing needs
- Sustain and expand internal resources
- Improve internal efficiency
IGR helps a business:
- Achieve operational efficiency
- Expand with new products/markets
- Focus on research and development
SGR has a few disadvantages:
- It often comes with an opportunity cost between dividends and reinvestment of profits.
- Businesses tend to focus too much on introducing new products or decreasing prices to retain the market share.
- External factors can change SGR quickly with no control by the management.
IGR also has some disadvantages:
- It depends on ROA and dividend payouts which are often mutually exclusive strategies.
- It does not encourage cheap debt financing sources.
- It hinders business growth if the business does not utilize external financing.