Financial sustainability means a company can earn enough money to pay for all its costs and still make a profit. As an investor, you always want to know:
- Can a business keep running?
- Can the organisation grow its revenue?
- Can your investment in the company provide good returns?
Here, the concept of financial sustainability comes into play. It shows whether your investment is safe and profitable. Be aware that a business that consistently generates revenue and surplus funds is more likely to survive economic downturns and offer stable returns.
Therefore, before investing, you should always assess whether a company has strong earnings and manageable expenses. But how can you make this assessment? In this article, let’s check out five key policies that most companies adopt to ensure long-term financial health.
5 key policies that show a company is financially sustainable
Recent research from McKinsey and Company shows that companies that have strong financial sustainability policies can enhance their operating profits by up to 60%.
Therefore, as an investor, you must check whether a company follows certain financial policies that give it long-term stability and allow it to generate consistent profits. Below are five key policies to look for:
1. Strong revenue generation strategy
You should see if the company has stable income sources. A financially sustainable company usually has:
- Multiple product lines
- Strong customer demand
- A competitive edge in its industry
If a company depends too much on one product or customer base, it may struggle if market conditions change. For example, - Say there is an seller active who sells one type of product, like phone cases. Now, if the market trends change or a competitor offers cheaper options, their sales could decline.
Hence, you should always look for companies with a steady revenue stream. Also, see whether it has a strategy to attract new customers (while retaining existing ones).
2. Smart cost management
Numerous studies have shown that a company with good cost management policies is likely to stay profitable. Ideally, to identify such companies, you should ask yourself these five key questions:
- Is the company’s operating cost stable or decreasing?
- Does the company maintain a healthy profit margin?
- How open is the company to using technology and automation?
- Does the company have a cost-cutting strategy without sacrificing quality?
- How does the company handle economic downturns or crises?
Please note that if a company spends too much without adequate earnings, it can quickly fall into financial trouble. Hence, look for firms that regularly review expenses and use technology to improve efficiency. These practices allow them to maintain long-term profitability.
3. Debt management and financial discipline
A company should not rely too much on borrowed money. That’s because excessive debt can become a burden (especially if interest rates rise). Here, you should check the company’s debt levels compared to its equity [debt-to-equity ratio (D/E ratio)] and see if it can easily repay loans.
For most companies, a D/E ratio of around 2.0 is considered safe. If this ratio is above 2.0, it means the company is heavily dependent on loans, which can be risky during tough economic times. Understand that debt levels differ by industry type.
While analysing the D/E ratio, you must note that different industries have different levels of debt. For example,
- Mortgage-based real estate firms and gambling businesses have higher debt ratios (above 2.2).
- Large banks have an average D/E ratio of 1.45, while smaller regional banks maintain a lower ratio of 0.63.
- Uranium mining has very low debt levels (D/E ratio of 0.02).
Therefore, to spot financial sustainability, you must first analyse the industry average D/E ratio. Next, look for companies with a D/E ratio close to the average.
4. Consistent profitability and cash flow
Profitability and cash flow are two important components of financial sustainability. You should check:
- Do the company consistently make a profit?
and - Does the company have enough cash to pay for day-to-day expenses?
Please note that even profitable businesses can fail if they run out of cash. Therefore, cash flow is an even more critical factor in judging financial sustainability.
As an investor, you should check how quickly a company can collect payments from its customers. Also, look for companies that report stable or growing profits and maintain a healthy cash reserve.
5. Long-term investment and growth plans
A sustainable company doesn’t just focus on short-term gains. Instead, it plans for the future! You should check if the company reinvests profits into:
- Research
- Innovation
- Expansion (such as developing an online marketplace to reach more customers)
Companies that invest in new products and better technology are more likely to grow over time. In contrast, if a company only focuses on cutting costs without investing in its future, it may struggle to compete later. Therefore, look for businesses with clear growth strategies and strong leadership.
Conclusion
Before investing in a company, you should check if the company is financially sustainable. This simply means that the company can keep earning profits after meeting all its expenses.
Generally, a good company should have multiple and stable revenue sources, such as an NBFC that generates income from lending, interest, and financial services
Also, there must be:
- Smart cost management policies
- A balanced approach to debt
- A healthy cash flow
These factors show that a business can survive tough times and provide steady returns. As an investor, when you pick financially sustainable companies, it gives you confidence that your investment is safe and has the potential to grow over time.