What is Sustainable Growth?

Banking & FinanceFinance ManagementGrowth & Empowerment

What is Sustainable Growth?

The main aim of financial planning is to get a balanced relationship between financial goals. It is based on the sustainable growth of a company given its established financial policies. As it is known, financial planning involves growth, investment, and financing. Therefore, to achieve sustainable growth, the firms need to create policies that augment the growth potential of a company to sustain in a long-term period.

Sustainable growth is a percentage measure of yearly growth in sales that is in sync with the company’s financial policies meaning no fresh equity is issued.

The following relationship may be used to measure the sustainable growth of a company −

$$\mathrm{SG=\frac{(Net\:Margin\:\times\:Retention\:\times\:Leverage)}{Assets\:to\:Sales\:-\:(Net\:Margin\:\times\:Retention\:\times\:Leverage)}}$$

The net assets to sales ratio provide an idea about the need for funds for investment in assets to get a desired level of sales. As is obvious, the funds' requirement will increase with the increase in sales. As the business expands based on increasing sales, it will need more assets which will require mode funds.

For example, in the case of a one-product company, increase in sales would need more production and market expansion to chart a sustainable growth path.

Dividends subtracted from net profits offer an idea about the internal source of funds. Thus, the product of net profit to sales ratio and retained profit to net profit ratio provides an idea of the funds available internally to sustain the growth in sales. Retained earnings enhance the debt-raising capability of a company and hence with more retained earnings, the company can attract more debt to invest in the expansion, or production. This helps the businesses have sustainable growth in the future.

Determinants of Sustainable Growth

The four financial policy goals that may be formed as ratios and that are considered while determining the sustainable growth model of a company include the following −

  • Target sales growth

  • Target return on investment or net assets

  • Target dividend payout, and

  • Target debt-equity or capital structure

There are both demand-related and supply-related financial goals that a company needs to ascertain in order to achieve a sustainable growth projectile. The demand-related goals are driven by the strategic planning of sales growth. This requires investment in fixed and current assets.

The supply-related goals are driven by the company’s desire to earn superior returns, pay shareholders dividends, and enhance funds in return for incurred debt backed by its internal funds.

Sustainable growth is a measured growth that can be expressed by four specific ratios that show the percentage growth of sales of a product in a yearly manner. The ratios are created in order to assess the growth of sales vis-a-vis the growth of the company.

If we consider the growth potential of a single-product company, its growth can be simply estimated by a model of interactions between four financial objectives that are expressed by ratios.

They are as follows −

  • Operating ratio of net assets to sales (NA/S)

  • Operating ratio of net profit to sales (PAT/S) a.k.a. Net Margin

  • Financial policy ratio of retained profit to profit (retained profit/PAT) also called the retention ratio

  • Financial policy ratio of leverage or debt-equity ratio (D/E).

Therefore, provided with the capital structure, the total funds would be equal to retained earnings with the addition of debt backed by retained earnings. Net assets or capital employed to equity is, therefore, a leverage measure that is equal to one plus the debt-equity ratio.

Conclusion

It is notable that in order to grow, companies may need additional debt. If the growth path of a company is clear and sustainable, it would be easier for the company to raise debt.

Therefore, sustainable growth and debt-raising are proportional to each other provided no retained earnings are used to fuel the growth.

raja
Updated on 27-Jun-2022 06:15:28

Advertisements