Financial Planning
How Fast Is Too Fast?
Growing too fast can be dangerous to your company's health. Use the Sustainable Growth Rate ratio to track your company's financial ability to grow.
by Charley Kyd, MBA Microsoft Excel MVP, 20052014
The Father of Spreadsheet Dashboard Reports

(Originally published in Inc Magazine.)
What typically tops the list of worries of the chief executive
officers of fast growing companies? Financing that growth,
according to surveys over the years. This is because many
companies are growing faster than they can afford.
Your company is growing faster than it can afford if you must
continually scramble to increase your debttoequity ratio, sell
stock, liquidate assets, or take more drastic measures to
finance your growth. But business life doesn't have to be like
that. It's possible to grow at an affordable rate.
Speaking at an engineering conference more than 50 years ago,
David Packard explained how the HewlettPackard Company
maintained an affordable growth rate during its first years of
fast growth.
From 1950 through 1957, Packard said, the company had increased
its sales twelvefold—without using any outside capital. HP
maintained this 43% growth rate by using a financial formula to
help it manage its growth.
This formula is what the firm calls its affordable growth rate.
But because most business texts use the term sustainable growth
rate (SGR), that's the term I'll use.
The SGR is a growth strategy based on two assumptions. The first
is that your sales can grow only as fast as your assets. If
yours is like most firms, for example, you can't increase your
sales by 30% unless you increase your receivables, your
inventories, and your fixed assets by about 30% as well.
The second assumption is that your firm has a target
debttoequity ratio, and that your lenders are willing to
continue to extend credit at that ratio. This assumption implies
that as your equity grows, debt can grow at the same rate,
allowing you to maintain a constant debttoequity ratio.
The SGR can be determined easily be considering the effect of
these assumptions on a fastgrowing company that plans to double
its sales yearly.
If sales are to double, assets must double (assumption 1). And
since the balance sheet must balance, total debt and equity must
double as well. Lenders will allow debt to double if equity
doubles (assumption 2). The growth rate of your firm's sales,
then, depends on the growth rate of its equity.
The SGR is equal to the annual percentage increase in the
stockholders' equity section of a firm's balance sheet. The
following display shows how the SGR can be expressed as a
formula:
Let's take an example. Suppose your company pays out 20% of its
earnings in dividends. The retention ratio (b) is therefore 80%.
(1.00 minus 20%); that is, your firm keeps 80% of its earnings.
If your company maintains a return on beginning equity (R) of
30%, your sustainable growth rate is equal to 80% times 30%, or
24%.
Notice in the formula that the stockholders' equity figure at
the beginning of the period is used to calculate R. When you use
balancesheet data in any SGR formula, always use data from the
beginning of the period. This is the same, of course, as using
data from the yearend balance sheet of the previous period. The
reason is that the SGR formula compares what you started with
(the balance sheet) with what you did with it (the income
statement).
What does an SGR of 24% mean? It means that if you maintain a
growth rate of about 24%, your financial growth will stay in
balance. A faster growth rate would force you to increase your
debt ratio or sell more stock. A slower growth rate would allow
you to reduce your debt ratio or buy your stock.
The SGR shows your firm's financial ability to grow through
performance. It's important that you keep this calculation in
perspective, however. As Packard told his audience, "In spending
most of my time talking about the financial aspects of growth, I
do not mean to imply that these are in any sense determining.
The other things you do determine how fast you grow, provided
you have the financial resources."
Applying the Sustainable Growth Rate
Although the SGR formula does calculate your sustainable growth
rate, it offers little insight if you wish to improve on that
performance. An expanded version of the formula begins to offer
that insight.
This formula shows that your sustainable growth rate is the
product of your earnings retention ratio (A), a leverage ratio
(B), your profit margin on sales (C), and the turnover of your
assets (C). ;
These four ratios represent two types of components. Earnings
retention and leverage, A and B, are decisions. Net profit
margin and asset turnover, C and D, are results.
The decision components are statements of policy. They reflect
the attitude that you, your investors, and your lenders take
toward your company's risks and opportunities.
The result components reflect the outcomes of managerial action
 in other words, operating performance. The net profit margin
indicates the market competitiveness of your firm, its operating
efficiency, and your ability to control overhead costs.
Asset turnover measures the ability of assets to produce
revenue. As Packard said in his speech, it measures the ability
of the sales group to sell its products to customers who pay on
time, the efficiency with which manufacturing uses its fixed
assets, and the ability of the purchasing group to deliver raw
materials to the plant when they are needed and not before.
Often, I'll combine the two decision components and the two
result components in an SGR formula. Since both decision
components tend to be relatively stable over time, I use a
constant in the calculation, based on their actual values. I
call this the decision multiplier. The profit margin multiplied
by the turnover is an overall measure of operating performance,
called the Return On Assets (ROA).
To illustrate, HP maintained a retention ratio of about 90% and
a debttoequity ratio of about 45% from 1975 to 1985. Its
decision multiplier is therefore 1.31 (90% times 1.45). HP could
express its sustainable growth rate as:
SGR = 1.31. x ROA
I like this version of the SGR formula because it emphasizes the
importance of operating performance to your firm's financial
ability to grow. Growth depends on operating performance, and
the ROA reflects that performance.
How should you use these SGR formulas? Most frequently, I
suspect, you will find them useful in your mental tool kit. With
the SGR in mind, for example, you will know that your friend's
company, which has an ROA of 35%, must be generating a lot of
cash if it is growing by only 20% a year.
You will also find the SGR to be useful during your planning and
budgeting cycle. Calculating an SGR allows you to step back from
the nittygritty details and determine the overall financial
performance necessary to finance the expected growth rate of
your sales.
But when you begin to apply these formulas to your own financial
statements, you'll probably encounter some difficulties. First,
of course, if you're losing money, you can't very well grow
through performance. You'll need to get your business into the
black before you can start thinking about a sustainable growth
rate.
Another problem you may experience is that your financial ratios
may jump around from month to month. What effect will these
fluctuating ratios have on your SGR? "Now, obviously," Packard
said, "you cannot control all of these factors on a daytoday
basis or even a yeartoyear basis to match this formula
precisely. But it does tell you how fast you can grow without
changing the ownership pattern, the debt structure, or any of
the other basic characteristics of your business.
"Actually, you can deviate quite widely from this on a
yeartoyear basis," Packard continued.
"For example, in our case, our profit has varied from 6% to 15%.
The turnover has gone as high as seven times per year in years
of very rapid growth, and on occasion it has gone below four
times."
Ratios like these are tough to achieve year after year. But such
ratios are what fastgrowing companies must maintain if they
expect to sustain their growth rates.
Whether your firm is growing quickly or slowly, however, it must
pay its own way over the long run. The SGR formula provides a
convenient measure of your financial ability to support the
growth rates of which we all dream.
