Discuss the concepts of internal growth rate and sustainable growth rate?

Answer 1

Both Internal Growth Rate and Sustainable Growth Rate refer to the amount of growth (defined as profitable increase in revenues) a business organization can achieve without having to resort to additional borrowed funds or additional outside capital infusion.

What's important about these concepts is that rapidly growing companies most often 'grow broke' on the balance sheet rather than the income statement. That's particularly true if they are in a 'make or distribute things business' that requires inventory and accounts receivable. In hyper-growth, the business won't generate enough funds from the 'next sale' to cover the working capital required to support that sale. So, knowing what the sustainable growth rate or optimum internal growth rate is - is important. With entrepreneurs particularly, when the firm is sales driven, it can literally grow itself broke by over-focusing on the income statement 'top line' and not paying attention to the balance sheet.

Here are some details on calculating:

For publicly held companies, this calculation can come right off the annual report financial statements. Sustainable Growth Rate = Return On Equity * (1- Dividend Payout Ratio)

Virtually all sources in the investing community will agree on this formula.

Internal Growth Rate = Retained Earnings / Total Assets

Again, for publicly held companies, this is easy to calculate right out of the annual report financials or 10k financials.

For privately held or family businesses, using retained earnings as the basis of these calculations is often not helpful. Privately held businesses are often "Sub-S" corporations or LLC's (Limited Liability Corporations). These forms of business entities typically do not build up retained earnings due to the way they are taxed at the federal level.

So, you have to look at a different calculation for these companies and there is less agreement on what the calculation looks like. For these entities, you are looking at a 'net cash flow' number as what's available to fund future growth without additional borrowed money. That looks like:

SGR = (Cash After Operations - (Debt Service + Distributions)) / Working Capital Current Cash After Operations in this approach is the cash remaining after all cost of goods and SG&A (selling, general and administrative) expenses have been paid

Debt Service would include both principal and interest payments on current debt from the current period.

Working Capital would be for the current period.