Internal And Sustainable Growth

Internal and Sustainable Growth

 

Once all expenses and debt are paid by a firm, the remaining net income is either paid in dividends and/or retained by the firm.  This is a big decision, because a firm pays dividends based on its desired capital structure and financing options.  Paying dividends tends to allow the firm to attract investors who want dividend returns and who will want to purchase the stock.  Based on the amount of dividends paid, the form will use its remaining retained earnings to finance the firm’s operations, working capital needs, and capital expenditures.  In order to calculate the internal and sustainable growth rates, the firm would first determine its dividend payout ratio and its retention ratio.

 

Investors and others (supply chain people) want to know how rapidly a firm’s sales can grow.  I sales grow, then assets such as accounts receivable (A/R) and inventory will grow to support sales.  The key from a supply chain standpoint would be to grow sales through minimal necessary growth in A/R and inventory.  A firm would generally rather internally finance its growth than obtain external financing for its growth.  A firm can earn and create cash flow to use for business needs or seek external financing by borrowing money or selling stock (if a privately owned firm, it would seek equity injections from current owners or from new investors).

 

Suppose a firm has a policy of financing growth using only internal financing.  This means that the firm will not borrow funds not sell stock to raise capital.  The internal growth gives the amount the firm can grow with internal funds.  The internal growth rate is equal to:

 

  • ROA*b/1-(ROA*b), where b is the retention ratio
  • Suppose that the ROA for a firm is 10.12% and the retention ratio is 2/3 (.667), then the internal growth rate would be .1012*.667/1-(.102*.667) = .0675/1-.0675= .0675/.9325= 7.23% (could also be 7.24% due to rounding).  This ratio indicates that 7.23% is the maximum growth rate (in sales and assets) the firm can achieve with no external financing. 

 

The sustainable growth rate is basically the same formula except that we use a firm’s ROE.  The sustainable growth rate is the maximum growth rate a firm can achieve with no external equity financing while maintaining constant debt to equity ratio.

 

Putting it all together, a firm’s ability to sustain growth depends on the following four factors:

 

  • Profit margin.  An increase in profit margin will increase a firm’s ability to generate funds internally and thereby increase its sustainable growth.
  • Total asset turnover. An increase in the firm’s total asset turnover increases the sales generated per each dollar of assets.  This decreases a firm’s needs for new assets as sales grow and thereby increases the sustainable growth rate.
  • Financial Policy.  We talked extensively about financial policy in week one and two.  An increase in the debt to equity ratio increases the firm’s financial leverage.  Since this makes additional debt financing available, it increases the sustainable growth rate.
  • Dividend policy.  A decrease of net income paid out in dividends will increase the retention ratio, increases internally generated equity and thus increases internal and sustainable.