Certified Management Accountant 2025 – 400 Free Practice Questions to Pass the Exam

The sustainable growth rate represents the maximum rate at which a company can grow its sales and earnings while maintaining its current financial structure, without needing to issue additional debt or equity. This concept is particularly important for financial managers to understand how to balance growth with the company's ability to finance that growth internally.

The correct definition of the sustainable growth rate is found by considering the return on equity (ROE) and the proportion of earnings that are retained in the business, which is indicated by (1 - dividend payout ratio). When a company generates a profit, a portion of that profit is typically distributed to shareholders in the form of dividends, while the remainder is retained in the company to reinvest and fuel future growth. By multiplying ROE by the retention ratio (which is essentially the remaining profits after dividends are paid), you calculate the sustainable growth rate, indicating how fast the company can grow without external financing based on its internal resources.

This understanding aligns perfectly with the financial principles that govern the balance between profitability, dividend policy, and growth prospects. Hence, the sustainable growth rate can be effectively calculated as ROE multiplied by the portion of earnings that is retained within the company, emphasizing the interplay between profitability and growth.

In contrast, net income times the dividend payout ratio does