Abstract
Financial sustainability is underrepresented in both the research on and practice of sustainability management and reporting. This article proposes a conceptual measure of financial sustainability and examines its association with capital market returns. The measure is positioned at the intersection of sustainability management, risk management and risk governance. Financial sustainability is regarded as a crucial control parameter complementing shareholder value and can be viewed by risk-averse investors as a secondary condition of investment decisions. It reduces refinancing and insolvency risks, leading to risk-adjusted excess returns in an imperfect capital market with financing restrictions and insolvency costs. We propose measuring a firm’s financial sustainability in terms of four conditions: (1) firm growth, (2) the company’s ability to survive, (3) an acceptable overall level of earnings risk exposure, and (4) an attractive earnings risk profile. We show that the application of a conditions-based investment strategy to European firms with high financial sustainability (i.e., firms fulfilling all four conditions) over the period from July 1990 to June 2019 results in monthly excess returns of 0.39%. This portfolio’s risk is lower than the risk of market investment. We find that the excess returns increase when incrementally adding each of the four conditions to the investment strategy.
Highlights
This article aims to develop a conceptual measure of financial sustainability, which represents a suitable assessment criterion for the purchase of company shares by long-term oriented, risk-averse economic subjects
We show that an investment strategy which only invests in firms with high financial sustainability—representing 15 European countries and covering the period from July 1990 to June 2019—results in a monthly return of 1.11%, i.e., 0.39% more than the market return
Financial sustainability is currently inadequately operationalised, it remains a latent construct that is important for risk and sustainability management
Summary
This article aims to develop a conceptual measure of financial sustainability, which represents a suitable assessment criterion for the purchase of company shares by long-term oriented, risk-averse economic subjects. We examine hypotheses on the relationship between this measure of financial sustainability and stock market returns, in particular the hypothesis that higher financial sustainability leads to higher risk-adjusted equity returns. The measure is positioned at the intersection of sustainability management, risk management and risk governance. Sustainability has become a widely accepted buzzword in both companies and society at large. It has become the main objective of management, as evidenced—in most industrial countries—by corporate governance codes expressing “good governance”, despite implementation differences between countries (for an international overview see Wymeersch 2006)
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