Measuring Sustainable Growth
Is there such a thing as too much growth? In financial management, we try to balance the management of growth with our asset base. For example, if sales were to grow too fast, than we would deplete our financial assets resulting in extreme risks to the organization. If sales grow too slow, than we run the risk of destroying value by holding assets that earn a rate below the cost of capital. The objective in financial management is to manage a sustainable rate of growth that creates value year after year.
The growth rate in sales is limited by the growth we can obtain from the equity side of the Balance Sheet. Therefore, sustainability is a function of equity growth rates, not sales growth rates. The formula for calculating a sustainable growth rate (G) is:
G = Margin x Turnover x Leverage x Retention
Margin = Net Income / Sales
Turnover = Sales / Assets
Leverage = Assets / Equity
Retention = % of Earnings Retained
Consequently, if we want to maintain a consistent level in profit margins, asset turnover, leverage, and retained earnings, than we should grow our sales by G (sustainable growth rate). Changing the sustainable growth rate is a function of the four components of sustainable growth. For example, eliminating marginal products can increase the Margin component or paying out less dividends will increase the Retention component. The trick is to manage the four components so that sales growth follows the sustainable growth rate.
Written by: Matt H. Evans, CPA, CMA, CFM | Email: firstname.lastname@example.org | Phone: 1-877-807-8756
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