A farm’s sustainable growth rate is the maximum rate of growth that the farm can sustain without having to increase financial leverage or look for outside financing. Sustainable growth rate can be computed using information on net farm income, owner withdrawals and net worth.
Specifically, to compute sustainable growth rate, subtract owner withdrawals from net farm income and divide the result by net worth. Owner withdrawals primarily consist of family living expenses but would also include money transferred out of the farm to invest in another business.
Net farm income minus owner withdrawals is often referred to as retained earnings. Increases in retained earnings increase a farm’s sustainable growth rate. Conversely, decreases in retained earnings decrease a farm’s sustainable growth rate.
The graph illustrates the sensitivity of the sustainable growth rate to changes in net farm income in relation to net worth (rate of return) and the proportion of net farm income withdrawn from the business (owner withdrawal rate). The sustainable growth rate ranges from 0.01, or 1%, for a rate of return of 4% and a withdrawal rate of 75%, to 0.06, or 6%, for a rate of return of 8% and a withdrawal rate of 25%.
Two key points can be garnered from the results in this example. First, even if the owner withdrawal rate is relatively low, at 25%, a farm with low financial performance will have a relatively low sustainable growth rate. Second, a farm with high financial performance and a relatively high owner withdrawal rate, at 75%, will also have a relatively low sustainable growth rate.
These results illustrate the importance of the magnitude of retained earnings, particularly in relationship to farm size as measured by farm net worth. Farms with little to no retained earnings have a limited ability to expand.
As noted, the information needed to compute a farm’s sustainable growth rate includes net farm income, owner withdrawals and net worth. Net farm income, arguably the most important input into the computation of numerous financial performance indicators, can be obtained from an accrual income statement. Owner withdrawals represent the amount of money withdrawn from the business for family living expenditures and other off-farm uses. Net worth is obtained from a market value balance sheet.
Langemeier is a Purdue University Extension agricultural economist and associate director of the Commercial Center for Agriculture. He writes from West Lafayette, Ind.