The concepts of sustainable and internal growth rates play a major role in determining the fate of any business. Both concepts are growth-related and closely linked, which is why they are sometimes confused to be the same.
But the two concepts are different in that Sustainable Growth Rate shows the rate at which a company can grow without using external equity financing but debt financing can be added to some extent. The extent should be so limited that debt/equity ratio of the company does not change. It other words, current proportion of debt and equity should remain the same. However, if retained earnings/equity increases, the loan can be borrowed in the same proportion.
Whereas, the Internal Growth Rate indicates the rate at which the company can grow without using any external financing, neither debt nor equity financing. It means the growth should only result from using retained earnings.
Each rate can be calculated with the help of formula and also has some advantages and disadvantages. Both rates determine the rate at which a company can grow but there is a difference between Sustainable and Internal Growth rates. Let’s first discuss what these two terminologies are.
What is an Internal Growth Rate (IGR)?
Internal Growth Rate is about the rate at which a company can grow with its internal resources without the help of external financing. This internal investment is made basically from the company’s earnings or its retained earnings. The amount is reinvested within the company. It means a company with higher income and retained earnings will have a higher growth rate and vice versa.
Internal Growth Rate (IGR) shows the ability of a firm to do its financing without using the other two methods namely debt financing and equity financing. This kind of metric is vital for startups. Startups can find it difficult to finance themselves from other methods. Hence, having a higher Internal Growth Rate will indicate that the startup can generate future sales.
Internal Growth Rate Formula
Internal Growth Rate = Retention Ratio x Return on Assets (ROA)
- Retention Ratio = (Net Income – Dividends) / Net Income
- Return on Assets = Net Income / Average Total Assets
Internal Growth Rate Examples
In business expansion terms, suppose a company sells casual women’s shoes and has successfully achieved customer loyalty. Now, the company wants to sell fancy shoes to increase its net income and sales. The Internal Growth Rate here will play a significant role. It will explain if the company extent to which it can finance its growth through reinvestment (company’s financing). If the required cost of capital exceeds the company’s internal growth rate, it will require adopting external financing methods.
What is the Sustainable Growth Rate (SGR)?
As the name suggests, it is a growth rate sustained by the firm without relying on external equity financing. So, the internal resources and taking debt are the business’s sources of financing. To keep this growth rate higher, the firm has to take measures to increase its income for reinvestment.
Moreover, the firm can use debt financing to keep the sustainable growth rate growing but it must not alter the debt to equity ratio. The financing structure remains the same, but the debt increases along with equity and this equity is increased by increase of retained earnings.
Sustainable Growth Rate Formula
Sustainable Growth Rate = Retention Ratio x Return on Equity (ROE)
- Retention Ratio = 1 – Dividend Payout Ratio
- Return on Equity = Net Income / Average Total Equity
Sustainable Growth Rate Examples
Suppose a local tourism company wants to expand its business to far-off areas. The sustainable growth rate will show how it can grow its business to far-off areas without relying on financing through external equity. If the company manages to grow its business within this rate, its debt-to-equity ratio will not change. However, if it exceeds the company will require equity financing.
Internal Growth Rate Vs. Sustainable Growth Rate
Sustainable Growth Rate and Internal Growth Rate are usually the same. But certain factors make the two rates different from each other. Key differences between sustainable growth rate (SGR) and internal growth rate (IGR) are discussed below:
SGR needs to be sustained when it is achieved, debt can be added to it to some extent. Whereas IGR needs to be achieved without relying on any external financing.
The Sustainable Growth Rate mainly depicts the stage of growth a business is in throughout its lifecycle, including the rate at which it can use its internal resources for growth purposes. Whereas the Internal Growth Rate exhibits operational proficiency.
Operational proficiency means it can tell the rate at which the company can generate sales and increase its net income with the available resources.
The sustainable growth rate is limited as it does not provide a comprehensive analysis for sustaining the growth rate. It becomes more difficult for the company to sustain the growth rate than to achieve the highest growth rate.
Advantages of IGR and SGR
SGR attempts to exhibit the company about its capital financing needs. It also tells the company how efficiently it can use its internal resources for business expansion and helps sustain internal resources.
The IGR helps businesses to work on their operational efficiency. It also helps in expanding to new markets with newly developed products. Through these factors, the internal growth rate ultimately helps the company to focus on research and development for innovation.
Disadvantages of IGR and SGR
SGR includes opportunity costs between dividends and reinvestment. Also, businesses tend to focus on retaining market share through price decline. Most importantly, Sustainable Growth Rate is affected by the external factors over which the organizations have no control. Such factors include inflation, environmental events, etc.
The internal Growth Rate also has some disadvantages, such as not supporting debt financing even when it is cheaper. It may ultimately affect the business growth negatively as some profitable external financing sources are avoided. It also depends on two mutually exclusive strategies, Return on Assets (ROA) and dividend payouts.
Sustainable and internal growth rates are different. Sustainable growth exhibits growth that can be achieved without external equity financing. However, debt financing can be raised to the extent it does not change the financing structure of the business. On the other hand, internal growth rate is solely dependent on the retained earnings/internal resources owned by the business.
SGR shows how the company can exhibit growth without a change in financing structure. It means how the business can sustain while achieving growth. On the other hand, IGR exhibits maximum growth that can be achieved with internal resources owned by the business.