Financial Ratios - Growth Potential Ratios

1. Sustainable Growth Rate

Formula 7.40

G = RR * ROE

RR = retention rate = % of total net income reinvested in the company
or, RR = 1 - (dividend declared / net income)

ROE = return on equity = net income / total equity

Note that dividend payout is the residual portion of RR. If RR is 80% then 80% of the net income is reinvested in the company and the remaining 20% is distributed in the form of cash dividends.

Therefore, Dividend Payout = Dividend Declared/Net Income

Look Out!

Students sometimes confuse retention rate with actual dividend declared. Students should read questions diligently.

Let's consider an example:

Segment Analysis

Segment analysis requires conducting ratio analysis on any operating segment that accounts for more than 10% of a company's revenues or total assets, or that is easily distinguishable from the other company business in terms of products provided or the risk/return profile of the segment. Lines of business are often broken down into geographical segments, when the size or type of business differentiates them from other business lines.
Since many segments have different risk profiles, they should be analyzed and valued separately from other parts of the business. Conducting ratio analysis, specifically profit margins, return on assets and other profitability measures can give analysts insight into how the segment affects overall financial performance. Both U.S. GAAP and IFRS require companies to report specific segment data, which is only a subset of the overall reporting requirements.

Ratio Analysis

Ratio analysis can be used to estimate future performance and allows analysts to create pro forma financial statements. Here is one example of how to estimate the future earnings potential of a firm. An analyst can first create a common-size income statement by dividing all accounting items by total sales. Using forecast assumptions the analyst then determines the amount of future sales. By multiplying the common-size percentages by the new sales amount, the analyst prepares a pro forma income statement that estimates the future earnings potential based on the expectations of future sales.

By using a range of values from the common-size statement and using a range of values for sales, the analyst can conduct a sensitivity analysis for each of the accounting items, such as cost of goods sold (COGS), profit margin and net income, to see how sensitive they are to changes in the amount of sales.

By understanding how each of these items correlate to the changes in sales, an analyst can create a function that provides output for these measures for any potential sales amount in the future. Using this function an analyst can conduct scenario analysis by choosing assumptions for different market situations and create for example a base case, upside and downside scenario.

Scenario analysis gives analysts an idea of the risks involved in operating a firm under different economic situations. To create an even more detailed probability distribution of potential values and risk, some analysts will conduct simulations that use a computer to produce many potential scenarios

Return on Equity and the Dupont System
Related Articles
  1. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  2. Investing

    Asset Manager Ethics: Investment Process and Actions

    Managers, in developing their investment process, need to determine some “general rules” that make it meaningful. We offer six.
  3. Professionals

    Career Advice: Financial Analyst Vs. Investment Banker

    Read an in-depth comparison about working as a Financial Analyst vs. working as an Investment Banker, two highly prestigious business careers.
  4. Professionals

    Advisors: Which Certifications Are Essential?

    The right advisor credentials can make all the difference, but wading through some 100 certifications can be a challenge. Here's some help.
  5. Investing Basics

    Asset Manager Ethics: Valuation Is A Tricky Business

    Asset managers must accurately represent all of a clients assets in the client portfolio. This can be tricky for unique and hard-to-value assets.
  6. Personal Finance

    Top 10 Most Valuable Sports Teams in 2015

    Cleats, pads and profits: we take a look at the top 10 most valuable sports teams in the world.
  7. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  8. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  9. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  10. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  3. Security Analyst

    A financial professional who studies various industries and companies, ...
  4. CFA Institute

    Formerly known as the Association for Investment Management and ...
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  3. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  2. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  3. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  5. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  6. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!