Sustainable growth rates: refining a measure

Abstract

Abstract The purpose of this paper is to improve clarity and financial analysis for calculating a firm's sustainable growth rate, a useful concept for firms growing very fast as well as those in financial distress. The paper is based on a review of literature and textbooks concerning the concept of sustainable growth rate. The sustainable growth rate is the rate at which a company can grow without creating a cash flow problem, a concept developed by Robert C. Higgins in 1977 and in 1981 extended by him for continuous time frameworks. For discrete time frameworks, his textbook describes sustainable growth rates as a product of four ratios: the profit margin, the retention ratio, the asset turnover and the financial leverage ratio, of which the latter divides closing total assets by opening equity. I agree with the components but suggest a slight modification. The leverage ratio should use the figures of the same date: it should use opening total assets divided by opening equity. Mathematically, this change would require modifying the asset turnover ratio to make it sales divided by opening total assets, instead of dividing by closing total assets as used by Higgins. This modification makes more intuitive sense since sales are created by assets rather than the other way round, which is far more indirect and remote and because of the timing problem. The paper provides a simple illustration. This modification would also require précising that the sustainable growth rate of firms in financial distress should use the asset turnover ratio using opening assets. Copyright © 2008 John Wiley & Sons, Ltd.