The tool referenced determines the maximum expansion rate a company can achieve without needing to increase financial leverage. It is calculated by multiplying a company’s retention ratio by its return on equity. This calculation provides a percentage representing how much a business can grow using only internally generated funds, assuming its debt-to-equity ratio remains constant. For instance, a business with a 60% retention ratio and a 15% return on equity has the capacity to expand at a rate of 9% sustainably.
Understanding a company’s capacity for expansion through internal funding offers several advantages. It helps management avoid over-leveraging the company, potentially averting financial distress. Additionally, it allows stakeholders to gauge the efficiency with which a business reinvests its earnings. Historically, this type of calculation has been a crucial element in assessing a firm’s long-term financial health and its ability to generate shareholder value while maintaining a stable financial structure.
