OLDIES, STILL
GOODIES
The Journal is pleased to reprise articles that are evergreen
to the industry. This article made the lenders’ hit parade in
1991.
How Much Growth Can
Borrowers Sustain?
by George W. Kester
H
ow many times have you been approached by a borrower
who is excited about the unlimited sales potential of his or
her firm’s products but who needs additional financing to
achieve that potential? How many times has the same borrower come
back and, instead of repaying the original loan, requested additional
financing because the working capital and fixed assets needed to support the sales growth have created a classic situation of being “profit
rich and cash poor”? This article explores this dilemma and suggests
a method for evaluating how much growth a borrower can sustain.
T
he situation in which a borrower requests
additional financing occurs all too frequently in commercial lending. It occurs for several reasons. One reason is improperly structured
loans. The borrower has obtained loans in the form
of 90-day notes to finance the permanent increases
in working capital associated with sales growth.1
Another reason is that even if a borrower’s working
capital is financed through long-term borrowings,
continued growth in sales requires additional investments in working capital, thereby necessitating more
loans.
Eventually, there’s a potentially dangerous situa-
tion of too much debt and too little equity. Either
additional equity must be obtained or the borrower
must reduce the rate of expansion to a level that can
be sustained without an increase in financial leverage. Indeed, bankruptcy courts are filled with cases
of companies that have expanded themselves right
out of business.
This article presents a method for evaluating
how much growth a borrower can sustain. Such
analysis is important for both borrowers and lenders
since it determines the level of sales growth that is
consistent with the realities of the company and the
financial marketplace.
© 2002 by RMA; originally published in the June 1991 issue of The Journal of Commercial Bank Lending, published by Robert Morris Associates. At the time, Kester was an associate professor of finance, Bucknell University,
Lewisburg, Pennsylvania, and formerly an officer with First Union National Bank in Charlotte, North Carolina. He is
now Martel Professor of Finance, Washington and Lee University, Lexington, Virginia.
49
How Much Growth Rate
Can Borrowers Sustain?
Sustainable Growth Rate
The sustainable growth rate (SGR) of a firm is
the maximum rate of growth in sales that can be
achieved, given the firm’s profitability, asset utilization, and desired dividend payout and debt ratios. If
actual sales growth exceeds the SGR, something
must give. The firm must become more profitable,
utilize its assts more efficiently, or reduce its dividend payout. Otherwise, the firm is faced with the
choice of controlling (reducing) its sales expansion or
obtaining additional external financing, in the form
of additional equity or debt exceeding the desired
maximum debt ratio. The latter, of course, could
lead to a problem loan situation.
To estimate a firm’s SGR, a simple model is
described based on the assumption that the future is
the same as the past with respect to the firm’s profitability and earnings retention ratio.
A simple model. In its simplest form, a firm’s
SGR is calculated by multiplying its return on equity
by RR—its earnings retention ratio, as seen in the
following equation2:
SGR Net Profit
Beginning Equity
RR
1
It is important to note that the firm’s most recent
year’s net profit should be divided by its beginning
equity—the equity balance at the beginning of the
period over which the net profit was earned.
An expanded model. It is more instructive and
analytically useful to expand the first equation to
reflect the components of a firm’s return on equity:
asset turnover, profit margin, and financial leverage,
as shown below:
SGR Sales
Beginning Assets
Net Profit
Sales
1
Debt
Equity
The RMA Journal July-August 2002
Balance Sheet and Income Statement Data
Year 1
Total Assets
$3,000
Total Liabilities
1,000
Stockholders’ Equity 2,000
Total
$3,000
Sales
Net Profit
Dividends
RR
2
Year 2
$3,300
1,100
2,200
$3,300
$4,000
400
200
Table 2
Variables for Sustainable Growth Rate Calculation
Asset Utilization
Sales/Beginning Assets = $4,000/$3,000 =
Profit Margin
Net Profit/Sales - $400/$4,000 Financial Leverage
Debt/Equity - $1,000/$2,000 Earnings Retention Ratio (RR)
(1 - Dividend Payout) = (1 - $200/$400)
1.33
0.10
0.50
0.50
An example. To illustrate the usefulness and
application of the SGR concept, suppose that a company’s abbreviated income statement and balance
sheet data are as shown in Table 1, above. Based on
these data, Table 2 shows the variables used to calculate the company’s SGR.
With these data variables, the sustainable growth
rate using the second equation is 10%:3
SGR Sales
Beginning Assets
SGR As an estimate of future sales growth, the second
equation implicitly assumes that the firm’s asset utilization, as measured by its sales-to-beginning-assets
ratio, and its profit margin, as measured by its profitto-sales ratio, will remain constant in the future. It is
also assumed that the firm’s leverage multiplier, as
measured by 1 plus its debt-to-equity ratio, and its
earnings retention ratio will remain constant in the
future. It is also assumed that no new issues of equity are expected. Based on these assumptions, the
first two equations calculate the maximum growth
rate in sales that a firm can achieve in the future.
50
Table 1
Net Profit
Sales
1
Debt
Equity
RR
[(1.33) (0.10) (10.50)] 0.50 10%
Given the company’s asset utilization, profit margin, financial leverage, and earnings retention ratio,
the maximum sustainable rate of sales growth that
the company can achieve is 10% per year. The result
of sales growth of 10% in 3 is shown in Table 3.
Table 3
Result of 10% Sales Growth in Year 3
Sales
Year 2 Sales x (1 + SGR) - $4,000 x (1.10) =
$4,400
Net Profit:
Sales x Profit Margin - $4,400 x 0.10 =
440
Earnings Retained:
Net Profit x Earnings Retention Ratio - $440 x 0.50 =
220
Assets:
Year 2 Assets x (1 + SGR) = $3,300 x 1.10 =
3,630
Shareholders’ Equity:
Year 2 Equity + Earnings Retained = $2,200 + $220 = 2,420
Liabilities:
Equity x (Debt/Equity Ratio) = $2,420 x 0.50 =
1,210
Total Debt & Equity
$3,630
Asset Utilization: Sales/Year 2 Assets = $4,400/$3,300 = 1.33
How Much Growth Rate
Can Borrowers Sustain?
This example is based on the assumption that
the company’s current asset utilization, profit margin,
financial leverage, and earnings retention ratio will
remain constant in the future. Of course, this may
not necessarily be the case. The second equation
also can be used to evaluate the effects of changes in
one or more of the input variables to the SGR model.
For example, assume that due to economies of
scale (operating leverage), the company believes that
its profit margin will increase to 12% in the future.
Also, assume that its asset utilization is expected to
improve, with the sales-to-assets ratio increasing to
1.50. If these improvements can indeed be achieved,
holding financial leverage and the earnings retention
ratio constant, the company’s SGR will increase to
13.5%:
SGR [(1.50) (0.12) (1 0.50)] x 0.50 13.5%
Let’s assume, however, that due to expected
demand for the company’s products, management
expects sales growth to be 25%, which exceeds its
SGR of 13.5%. In this case, the company is faced
with the choice of accepting a lower rate of sales
growth, increasing the earnings retention ratio
(reducing dividend payout), or obtaining additional
external financing. Assume that management is willing to reduce dividends from 50% to 30% of net
profit, increasing the earnings retention ratio to 70%.
This will increase the SGR to 18.9%, which is still
lower than the expected sales growth of 25%:
Solving for Other Variables
To answer this question, the second equation
can be rearranged to solve for the required debt-toequity ratio needed to achieve a target SGR, assuming no changes in the firm’s asset utilization, profit
margin, and earnings retention ratio, as follows:
Target SGR
Net Profit
Sales
RR
Sales
Beginning Assets
1
3
Continuing this example, the company’s debt-toequity ratio must increase from 0.50 to 0.98 in order
for the company to achieve the expanded sales
growth rate of 25%:
Required Debt-to-Equity Ratio 0.25
1 0.98
(1.50) (0.12) (0.70)
This can be shown by recalculating the company’s SGR using the second equation:
SGR [(1.50) (0.12) (1 0.98)] 0.70 25%
Of course, a debt-to-equity ratio of 0.98 may not
be acceptable to either the company’s management
or its lenders, in which case other alternatives must
be explored. These alternatives include the often
hard-to-swallow prospect that the expected sales
growth simply cannot be achieved.
The second equation also can be rearranged to
solve for the other variables in the SGR model, given
a target SGR. The fourth equation calculates the
asset utilization needed to achieve a target SGR,
assuming no changes in the other variables.
SGR [(1.50) (0.12) (1 0.50)] 0.70 18.9%
This leaves only two alternatives: Accept a lower
growth rate in sales or obtain additional financing. If
management is unwilling to accept a lower rate of sales
growth and if additional equity is not feasible or desirable, the only alternative left to the firm is to overextend itself by obtaining debt exceeding its desired
maximum debt-to-equity ratio, which may be unacceptable to the company’s management or lenders.
How much must the debt-to-equity ratio increase to
support the expected sales growth rate of 25%?
Required Debt-To-Equity Ratio Required Asset Utilization Target SGR
Net Profit
Sales
1
Debt
Equity
RR
4
The fifth equation calculates the profit margin
required to achieve a target SGR, assuming no
changes in the other variables.
Required Profit Margin Target SGR
Sales
Debt
1
Beginning Assets
Equity
RR
5
And, finally, the sixth equation calculates the
earnings retention ratio required to achieve the target SGR, assuming no changes in the other variables.
Required Earnings Retention Ratio Target SGR
Sales
Net Profit
Debt
1
Beginning Assets
Sales
Equity
6
51
How Much Growth Rate
Can Borrowers Sustain?
Returning to the example, assume that the
required debt-to-equity ratio of 0.98 is indeed unacceptable. What level of earnings must be retained for
the company to achieve the expected sales growth
rate of 25%, assuming the debt-to-equity ratio remains
at its current level of 0.50? The earnings retention
ratio in the sixth equation must be increased to 92.6%.
Retained Earnings Retention Ratio =
0.25
[ (1.50)( 0.12)( 1 0.50) ]
0.926
Sustainable Growth Rate
Return on
Equity
(ROE)
1 Debt
Equity
Multiplied
by
Profit
Margin
Net Income Divided
by
Total
Subtracted
Expenses
from
52
Cost of
Goods Sold
Selling and
Administrative
Expenses
Interest
Income
Taxes
Sales
The RMA Journal July-August 2002
This can also be shown by recalculating the
company’s SGR using the second equation:
SGR [ (1.50) (0.12) (10.50) ] 0.926 25%
Extending the well-known DuPont chart
method of breaking a ratio into its various components, the illustration below shows a graphic depiction of the SGR model reflected in the second equation. This chart demonstrates the effects that various
policies and decisions are likely to have on a firm’s
SGR.
For example,
Sustainable
the effects of
Growth
improving asset
Rate
turnover can easily
be traced through
the chart to the
Retention
Multiplied
Ratio
likely impact on
by
(1 - Payout)
SGR, thus highlighting the importance of effective
Return on
cash, receivables,
Assets
(ROA)
and inventory management and the
efficient utilization
of fixed assets.
Multiplied Total Asset
Turnover
by
Similarly, the effect
of a change in the
dividend payout
ratio or improved
Sales
profitability
through greater
expense control can
be traced through
Total
Divided
Sales
the chart.
Assets
by
It should be
pointed out, however, that changes
Current
Fixed
Plus
in one variable may
Assets
Assets
affect one or more
variables included
in the model. For
Marketable
example, tighter
Cash
Securities
control of receivables may result in
additional expenses
Accounts
as well as a decline
Inventories
Receivable
in sales. Or an
How Much Growth Rate
Can Borrowers Sustain?
increase in fixed assets to expand
capacity, which initially reduces
asset turnover, may increase a
firm’s expected sales profits.
Using the SGR Model in
Commercial Lending
As should be apparent from
the foregoing straightforward
examples, the SGR model is simple to use and provides an estimate of the level of sales growth
a borrower can achieve, given his
or her current or expected asset
utilization, profitability, financial
leverage, and earnings retention
ratio. To the extent that actual or
planned sales growth exceeds the
estimated SGR, a potential problem loan is in the making. At a
minimum, a significant divergence between expected sales
growth and the estimated SGR
should serve as a warning signal
to lenders, prompting further
investigation and discussions
with the borrower.
Using the SGR model provides a convenient means for
checking the consistency of the
borrower’s growth plans.
Borrowers often desire the best
of all worlds: high sales growth,
low levels of debt, and high dividends. As is often the case, however, these objectives may be
inconsistent with each other. And
it is certainly better to recognize
these inconsistencies before the
fact rather than after.
Also, illustrated, the SGR
model and its variations provide a
convenient method of performing sensitivity analysis on the key
variables that affect a company’s
sales growth. What improvements are necessary in the company’s asset utilization or profitability to achieve the desired or
expected level of sales growth?
What level of debt is required,
and is it acceptable to the borrower and its lenders? Can the
expected or desired level of sales
growth be realistically attained,
given the constraints placed on
the company?
Conclusion
In short, the SGR model can
be a valuable tool for commercial
lenders in assessing their borrower’s ability to plan for and manage growth in a financially sound
manner. Lenders must be comfortable that their borrowers
understand that a business cannot just continue to expand without making adequate plans for
financing that growth. Otherwise,
borrowers and lenders are faced
with the perpetual problem of
continuous requests for renewals
and additional loans. ❐
Notes
1 See George W. Kester and Thomas W. Bixler,
“Why 90-Day Working Capital Loans Are Not
Repaid on Time,” The Journal of Commercial
Bank Lending, August 1990, for a discussion of
permanent and temporary working capital.
2 This model is derived from a more elaborate
model developed by Robert C. Higgins, “How
Much Growth Can a Firm Afford?” Financial
Management, Fall 1977. Also see Robert C.
Higgins, “Sustainable Growth Under Inflation,”
Financial Management, Autumn 1981, and Dana
J. Johnson, “The Behavior of Financial Structure
and Sustainable Growth in an Inflationary
Environment,” Financial Management, Autumn
1981.
3 The same results can be obtained by using the
first equation:
SGR SGR Net Profit
Beginning Equity
$400
$2,000
RR
0.50 10%
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