How to calculate the sustainable growth rate

The sustainable growth rate refers to the rate at which a business can increase profits without borrowing from financial institutions or investors. For small business owners, this rate describes annual profit growth without needing additional investment of personal capital or bank loans. Both small and large business owners need to calculate the sustainable growth rate and use it to determine whether they have sufficient capital to meet long-term development needs.

Divide the revenue by the total assets. This is the asset utilization ratio, which is the percentage of annual revenue relative to total assets.

• For example, if the total assets at the end of the year are 100 billion VND and the total revenue for the year is 25 billion VND, the asset utilization ratio is 25/100 or 25%, meaning that each year, you generate revenue equivalent to 25% of the total assets.

Divide net profit by total revenue. This is the company's profitability ratio, or the percentage of total revenue retained at the end of the year after all expenses are paid. (Net profit is revenue minus expenses).

• Example: If the net profit is 5 billion VND, the profitability ratio is 5/25, or 20%, meaning that each year, the company retains 20% of its revenue, while the rest goes towards covering business expenses.

Divide total debt by total equity. This is the company's financial leverage ratio.

• To calculate total equity, subtract total debt from total assets.
• Example: If total debt is 50 billion VND and total equity is 50 billion VND, the financial leverage ratio is 100%.

Multiply the asset utilization ratio, profitability ratio, and financial leverage ratio together. By multiplying these three ratios, we get the return on equity (ROE). The ROE is the ratio of the company's retained profit, used to generate future earnings.

• Example: Multiplying the three ratios together, 25% x 20% x 100% results in an ROE of 5%.

Divide the total dividend by the net profit. This is the dividend payout ratio, or the percentage of earnings paid to shareholders. (If you own a small business, any money you retain for yourself at the end of the year, beyond your salary, is considered a dividend).

• Example: If the net profit is 5 billion VND and the dividend payout is 0.5 billion VND, the dividend payout ratio is 0.5/5 = 10%.

Subtract the dividend payout ratio from 100%. This is the company's retained earnings ratio, or the percentage of net income that the company keeps after paying dividends.

• Example: 100% - 10% = 90%, which is the retained earnings ratio.
• The retained earnings ratio is crucial because it indicates how much income will be used for dividends in the sustainable growth rate, assuming the same dividend payout ratio will be maintained in the future.

Multiply the retained earnings ratio by the ROE. This gives the sustainable growth rate. This ratio shows the profits generated from business investment without the need for issuing additional shares, increasing equity, taking on more debt, or boosting marginal profits.

• Example: Multiply the previously calculated ROE by the retained earnings ratio, 5% x 90%, resulting in a sustainable growth rate of 4.5%. This means the business can achieve a reinvestment rate of 4.5% annually.

Calculate the company's actual growth rate. This rate simply reflects the increase in revenue over a given period. Divide current revenue by revenue at the starting point. It's best to calculate the actual growth rate over the same period used to calculate the sustainable growth rate.

• The actual growth rate will vary depending on the time period used, such as monthly, quarterly, or any other period used for financial reporting. Since it only reflects changes in revenue, this figure will fluctuate frequently.
• When calculating the actual growth rate, make sure to use the same time intervals. Comparing revenue from Q4 of the previous year with the first month of the new year will result in a significantly higher growth rate than it truly is. Ensure you are comparing like periods, such as week-to-week, month-to-month, quarter-to-quarter, year-to-year, etc.

Compare the actual growth rate with the sustainable growth rate. Your company might be growing faster, slower, or at the same rate as the sustainable growth rate. While rapid growth seems like a positive indicator, growth that exceeds the sustainable rate suggests the business does not have enough cash flow to meet operational needs at its current pace. If your sustainable growth rate is higher than your return on equity, this signals that your business is underperforming.

• For example, imagine a construction company building homes. To start, the owner invests 100 billion VND and takes a loan of 100 billion VND. After one year of business, the owner calculates the actual and sustainable growth rates and finds the actual growth rate is much higher than the sustainable rate. As revenue increases, the owner needs more capital to cover labor and material costs to build more houses for increased income. While increasing revenue is good for the business, the owner can't cover all costs without taking out more loans. By understanding the differences between growth rates, the business owner can plan where to borrow funds or decide whether to slow down the company's growth.
• Although a high actual growth rate is not always negative, it means the business needs to cover rising operating costs by issuing more shares, taking on new debt, cutting dividends, and increasing marginal profits. Most new business owners prefer not to take on additional debt or issue more shares in the early years, and aim to keep growth at a sustainable rate.
• If the actual growth rate is lower than the sustainable rate, it suggests that the business is not performing as well as desired.

Adjust your business operations. Use your understanding of the actual and sustainable growth rates to modify your business plan. If you want to maintain a growth rate higher than the sustainable rate, you need to cover the increased costs before reaping larger profits. Consider borrowing, issuing more shares, investing personal capital, or reducing dividends. If you don't want to take such actions, reduce the company's growth rate to a sustainable level and avoid needing extra capital to cover costs.

• If the actual growth rate is lower than the sustainable rate, you have more assets than necessary. If you don't plan to expand production, consider paying off debts or distributing dividends to shareholders.

Maintain your perspective. Keep in mind that growth rates are calculated based on past performance and do not fully predict the future. Actual and sustainable growth rates will not always align perfectly, so these rates should be used as a guiding tool for business decision-making, not as a basis to delay decisions or limit business activities. Over time, the sustainable growth rate will become more meaningful, and your business will gain more credibility. In the first year of operation, both the actual and sustainable growth rates may fluctuate significantly, which is normal.