When we have to make a proforma or projection of financial statement, we always deal with how to determine growth. There is a correlation between sales growth and financial policy. As sales increase, so do total assets. Firm has to invest in working capital and additional fixed assets to support sales growth. The increase in assets will also increase in total liabilities or equity. So, how to determine sales growth rate? In the long range planning, we could use Internal Growth Rate or Sustainable Growth Rate.
INTERNAL GROWTH RATE
Internal growth rate is defined as the maximum growth a company can attain without relying on external sources of finance/ Internal growth rate signifies that how rapidly a firm grows using its own or internal financing (does not borrow more debt or issuance of new stock).
where b = 1 – Dividend Payout Ratio.
SUSTAINABLE GROWTH RATE
Sustainable growth rate is defined as the maximum growth a company can attain by maintaining debt-equity ratio but no external equity financing. Various reasons a firm avoid equity sales because equity sales tend to expensive. And sometimes it could be troublesome to add more shareholders. The formula of sustainable growth rate is:
If we remember the DuPont ratio, we can understand that firm’s ability to sustain growth depends of these factors:
- Net profit margin, the more profit generated the more internal financing you get;
- Dividend policy, the more you retain the more you can support your sales growth because your retained earning grows well;
- Financial policy, maintaining the debt-equity ratio will also maintaining interest expense which affect net profit margin;
- Total asset turnover, higher total asset turnover means more sales generated for each dollar in assets.
NOTE ABOUT SUSTAINABLE GROWTH
If we calculate ROE using the ending book value of equity, than the formula above is correct. If we calculate ROE base on beginning book value of equity, then the formula become:
Sustainable Growth Rate = ROE x Retention Rate