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Foundations

Fundas: Self Sustainable Growth Rate

SGR.png

In our funda series, we bring in a term that’s not often understood: The Self Sustainable Growth Rate.

What is the maximum growth in sales a company can achieve without raising external capital? The answer to that lies in the self sustainable growth rate (SGR) that the company clocks.

When a company intends to increase its sales it will have to invest in working capital (receivables, payables and inventories) and fixed assets. Simply put, if you have to sell more gadgets, you have to make more gadgets and push them out the door. For that you need cash to make those gadgets (or increase your payables), push up your inventories and then spend more on sales and marketing.

These can be financed internally or externally. The company can grow internally by posting higher profits and then investing the same in the business. However if the profits are not sufficient to fund its growth it will have to rely on external sources of funding. What are then those external sources of funding? The company can raise debt or issue equity, but there are costs associated with this form of funding. The company will have to pay interest on the debt it has raised and there is dilution of equity if it decides to raise equity.

Companies also can use a mix of debt and equity to fund its growth. However nothing beats if the company is able to grow internally i.e through the profits that it generates. But how far or what is the maximum growth in sales the company can achieve if it relies on its internal sources of funding (profits)? The answer to that lies in the self sustainable growth rate (SGR) 

“SGR is the maximum rate of growth in sales a firm can achieve without issuing new shares or changing either its operating policy (its operating profit margin and capital turnover remain the same) or its financing policy (its debt-to-equity ratio and dividend payout ratio remain the same” 

What are the ​​​​​​​levers for the SGR? The company’s operating metrics and its financing policy. Hence SGR can be altered i.e increased or decreased depending on how the company manages its operating and financing policies.

How is the SGR arrived at?   

                                          SGR = Retention rate * Return on equity 

Retention rate is the percentage of earnings a company retains and reinvests in its business.

For e.g if a company makes a net profit of Rs 100 and distributes Rs 30 as dividends, it has retained Rs 70 in the business and reinvested the same. The retention rate in this case is 70/100 or 70%. The retention rate can also be arrived at as (1-Dividend payout ratio), DPR is the dividends/net profits, in this case it is 30/100 or 30%, hence retention ratio is (1-30%). This is easily available on a screener – however in India you have to assume that if they pay out Rs. 30 as dividend, they lose Rs. 36, because of the 20% Dividend Distribution tax on such payouts.

Below is the dividend payout ratio (DPR) of TCS over the last five years

Fundas: Self Sustainable Growth Rate
So the retention rate in FY18 for TCS was 1-37.06%= 63%. TCS reinvested 63% of its profits in its business. (We just ignored the dividend distribution tax)

Return on equity is Profit after Tax/Owners Equity and indicates the return that the shareholders get by investing their monies in the business. We had covered the concept of ROE in the funda series here. The ROE of TCS is 30%, hence the SGR of TCS at the end of FY18 was 19%

                                                            SGR = 63% * 30% 

So the maximum sales growth that TCS can achieve in FY19, while maintaining its current operational and financial policies is 19%.

In basic terms, the SGR or the maximum sales growth that a company can achieve is the product of what the company retains after paying dividends and the returns it can get on those profits, which is captured in the form of the ROE.

However investors need to keep the below things in mind while analyzing the SGR

  • It is the maximum sales growth that the company can achieve if it maintains its current operating margins, capital turnover, debt/equity ratio, dividend payout ratio and tax rates. It may be possible that the sales growth is greater than 19% in FY19 for TCS, if that is the case then investors need to look at any of the metrics discussed above or change in the cash position of the company.
  • Sales growth that the company records is dependent on the market conditions. If the SGR for TCS is 19% then it does not mean that they will achieve this sales growth next year. If it is higher then metrics discussed above need to be checked or if it is lower, it may be the case that the company is operating in tough market environment

Application

Let us take examples of a couple of companies listed on the Indian stock market and interpret the  SGR

Ramkrishna Forgings

Fundas: Self Sustainable Growth Rate

If you observe in three of the four years the sales growth has been greater than the SGR. In FY17 the company has recorded negative sales growth.

Take the case of FY15, the company achieved an impressive sales growth of 72%. The SGR at the end of the previous year was 1.69%, certainly this growth couldn’t have come at the back of its operating and financing policy at the end of FY14. What then did the company do that led to an impressive sales growth of 72%

  • Increase in debt by 47% from Rs 479 Cr to 703 Cr
  • Paying out fewer dividends during the year, resulting in dividend payout ratio of 30% at the end of the year. It is natural for a company to retain profits when it has scope to grow its sales
  • Equity dilution – company issued 13 lakh shares during the year
  • Improvement in the operating profit margins and capital turnover

In FY17 the company posted a negative sales growth of 2%, although it could have grown its sales by 12% which was the SGR at the end of the previous year. Possible reasons for the negative growth could be tough market conditions and increasing competition. Companies where the sales growth is higher than the SGR will have to resort to debt, equity dilution, or keep improving its operating metrics and tap its cash reserves if it were to maintain this trend. Companies falling in this category where the sales growth is higher than SGR are facing a funding problem, they will have to primarily focus on continuously raising debt and dilute equity to achieve sales as there is limited scope to drastically improve operating profit margins and capital turnovers.

Tasty Bite Eatables 

Fundas: Self Sustainable Growth Rate

In the case of tasty bite eatables the SGR has been greater than the sales growth in the last two years. The company could have achieved maximum sales growth of 25-30% in FY16 and 17, however sales growth were well below the SGR. In this case the company does not have look for external sources of funds to grow its sales and is yet to tap its full potential to grow its sales. In the case of Tasty Bites the SGR is increasing since FY15, the company has not diluted any equity and its debt/equity ratio has declined over the period. Companies falling in this category where the SGR > Sales growth will generate cash, which can then be used to retire debt, buy back shares, invest to create assets for future use or declare dividends. When the need arises the company can also increase its sales growth without external funding if it maintains its current SGR.

Final Thoughts

The self sustainable growth rate (SGR) is an important tool in an investor’s arsenal. It is amongst the many tools that can be used to make an investment decision. Managements of companies during its conference calls give guidance for sales and profits. If a company forecasts a sales growth that’s dramatically higher than the SGR, then you have to ask:

  • Are they going to reduce dividend payouts?
  • Are they expecting to increase margins to generate more cash (which can thus fund the higher sales growth)?

If not, then be ready for them to take on more debt or to dilute their shareholding. The SGR might be a good way to determine what course a company will take going forward.

References
Finance for Executives- Managing for Value Creation, 4th Edition, Hawawini Viallet


NOTE: Please do not consider this article as a recommendation, It is purely for informative purpose only. Authors may have positions in the stocks mentioned, so consider our analysis biased. There is no commercial relationship between Capitalmind and the companies mentioned in this analysis.

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