PRAT Model

What is the PRAT Model?

The PRAT model, also known as the sustainable growth rate (SGR) model, is used to describe the optimal rate of growth a company can achieve without borrowing more debt or using equity. The PRAT model aims to help companies boost their sales and revenues without increasing their financial leverage.

Companies that attain sustainable growth rates are able to avoid being over-leveraged and getting into financial distress.

PRAT Model Explained

Invented by an American professor, Robert C. Higgins, the PRAT model uses several variables to determine a company’s optimal growth rate: The variables are:

• P – Profit margin
• R – Retention rate
• A – Asset turnover
• T – Financial leverage

Take note that leverage is represented by T and not L. To calculate a company’s SGR, one multiplies the four metrics. Simply put, SGR = PRAT.

Practical Example

ABC Ltd. reports a profit margin of 13%, an asset turnover rate of 2, a leverage ratio of ½, and it makes dividend payments amounting to 60% of its earnings. Compute the rate at which ABC Ltd. can grow indefinitely:

Considering that 60% of the earnings are used, the amount that is retained is 40%.

SGR = PRAT = 13% * 0.4 * 2 * 0.5 = 5.2%

Assumptions

The figure above means that the company can continue to grow at a steady rate of 5.2%. However, the PRAT model is based on a couple of premises. It assumes that the company in question would like to:

1. Work with a fixed capital structure without having to issue new equity
2. Retain a target dividend ratio
3. Boots its sales as quickly as the market conditions allow

Company Operations and the PRAT Model

For any company to function above its sustainable growth rate, it needs to focus on sales, as well as on its products and services that carry the highest profit margins. Managing inventory is also vital to attaining the desired SGR level.

To a great extent, the PRAT model helps companies assess how well they are managing their day-to-day operations, which includes recovering owed debts and paying bills. By managing short-term debts effectively helps to ensure that they have a constant flow of cash.

The Unsustainability of High SGRs

While attaining a high SGR is a good indicator of a company’s performance, it may be difficult to maintain such a growth rate in the long run. As sales continue increasing, the company is likely to reach a sales saturation point.

The saturation point refers to the point at which a particular product or service reaches its maximum potential to the extent that its supply exceeds its demand. One way to overcome the problem is to diversify operations to a range of other products that are likely to bring in profits.

Despite the risk of reaching a sales saturation point, companies should aim for high SGRs. If they’re not working towards such a goal, they risk experiencing stagnation.

Whenever a company grows at a rate that exceeds its SGR, one or a combination of the four factors must be altered. If its normal growth has exceeded the sustainable rate on a temporary basis, they can borrow funds to finance any deficits. However, if the actual growth exceeds the sustainable level for a very long time, management needs to come up with a financial strategy from these alternatives: issue new equity, raise its financial leverage permanently (i.e., utilize debt), cut back on dividend payments, increase its profit margin, or reduce percentage of total assets relative to sales.

Practically though, most companies are hesitant to consider any of the solutions mentioned above. If they issue new equity, they can end up incurring high costs. On the other hand, raising the financial leverage is only feasible if a company holds unused debt or assets that can be pledged. If they opt to reduce dividend payments, this may lead to a fall in share price.

All the factors above show how hard it can be for companies to sustain a high SGR level. It is why the majority of well-established companies maintain their growth rates at levels less than the sustainable growth rate. For such businesses, their aim is to identify more productive uses of their current cash flows, so that they exceed their expenses.

Summary

The PRAT model, or the SGR model, is the optimal growth rate of business sales. It takes the following factors into account: a company’s profitability, asset utilization, debt (financial leverage), and dividend payouts. Although the company should aspire to achieve a high SGR, it should also think about how it’s going to maintain the growth rate.

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional CFI resources will be very helpful:

• Analysis of Financial Statements
• Debt vs Equity Financing
• Leverage Ratios
• Valuation Multiples
• See all valuation resources
• See all accounting resources