Internal Growth Rate
The Internal Growth Rate (or IGR) is the maximum growth rate that the company is confident of achieving without obtaining funding from outside. This is the growth rate at which the company assumes it will continue to grow the business and run its operations.
IGR indicates how much a company can expect to grow if it only uses the earnings it generates from its operations. That is why we also call IGR an operational growth rate because it does not consider any kind of debt or equity injection from outside. Also, this ratio is internal to the company as this is the rate at which the company would grow without borrowing money from outside.
Startups and small businesses pay a lot of attention to the internal growth rate. It talks about the firm’s capability to increase sales and profit without issuing any further equity or debt. Thus, an analyst comparing the IGR of two companies will always prefer the one with a higher IGR.
Formula of Internal Growth Rate
The company needs to calculate the internal growth rate. It helps the management to understand where they stand in terms of achieving organic growth without external funding. Since there is no financial leverage in the form of debt funding, the formula to calculate IGR is simple. We can calculate it by multiplying Return on Assets (RoA) with the retention ratio.
To calculate the ROA, we will have to divide the net income by the total assets of the company. Total assets include both short and long-term assets of the company that it is using to run and expand the operations of the business.
On the other hand, the retention ratio is the percentage of earnings that the company reinvests for internal expansion and growth. Or, we can say retention amount is the leftover after distributing the dividends and all other expenses.
Following is the formula:
Internal Growth Rate = Retention ratio x ROA or (1- Dividend payout ratio) x ROA
You can also use Internal Growth Rate Calculator.
Assumptions for Calculating Internal Growth Rate
- The dividend payout ratio should be as per the targeted rate.
- Sales and assets are related proportionally. This means an increase in sales would cause an increase in the assets in direct proportion.
- A company does not raise funds in the form of equity capital or debt.
- To achieve the IGR, the firm must finance all additional funding requirements from retained profits.
- PAT or profit after tax should be directly proportional to the revenue.
Two companies, Micro Ltd. and Max Ltd., has net earnings of $20,000 and $25,000 after-tax payments, respectively, and both have distributed 75% and 77.5% of earnings as dividend among the shareholders. Total assets of both Micro Ltd. and Max Ltd. are $50,000
|Particulars||Remarks||Micro ltd.||Max Ltd.|
|Retention Ratio||1 – Dividend Payout Ratio||25%||22.5%|
|Return on Assets||PAT / Total Assets||40%||50%|
Therefore, Internal Growth Rate of:
Micro Ltd. = 25% * 40% = 10%
Max Ltd. = 22.5% * 50% = 11.25%
A higher IGR is considered better as it means the company is generating more profits by utilizing the retained earnings. In the example above, Max Ltd. has a higher internal growth rate even though both the companies had the same amount of total assets. This means Max Ltd. is better at utilizing its funds even after paying more dividends than Micro Ltd. It also shows how far a company can grow on its own resources and the kind of profits/return it can generate. And if this rate of return is higher than the Risk-Free Rate of Return or relatively safe level of returns available in the market. Then it becomes preferable to deploy the funds more to the company rather than distributing them as dividends. And this will be beneficial for both the shareholders as well as the company.
How to Increase IGR?
IGR tells if a company is using the available resources efficiently or not. Efficient here means both – optimum utilization and no wastage of resources. A company might have a positive IGR, but still, it is not maximizing the existing resources. In such a case, the company can raise the IGR by putting the resources to good use.
To do so, the company should regularly evaluate its current operations to find room for improvement. For instance, a company can make its production process more efficient by using the Just-in-Time inventory management method. Or, the company can make efforts to reduce the cash tied with the inventory by improving its inventory turnover.
If a company is unable to raise its IGR from the available resources, then it could do the following things. To raise the IGR, it can add new business lines that match its current offerings. Moreover, adding more markets for the products or pushing the sales of products would also help in raising the IGR.
Internal Growth Rate provides an idea of efficiency in earnings by the company using internal sources, but no company or business can completely depend on its internal sources. It has to go for external borrowing. And in such a case, the internal growth rate is of no use or remains only relevant by exception. One should use a sustainable growth rate. It uses return on equity instead of return on assets.
Internal Growth vs. Sustainable Growth
By now, we are clear on what IGR is and how to calculate it. Often we use IGR along with other similar terms such as sustainable. However, it is vital to understand the difference between them.
The sustainable growth rate is the percentage growth in revenue that is in line with the financial goals of a firm. It allows the company to go for the outside funds (only debt, no equity) but in proportion to the company’s current capital mix. The sustainable growth rate will always be more than the IGR.
Another growth rate is the optimal growth rate. It is sustainable growth from a shareholder return creation and profitability point of view, irrespective of the company’s financial plans.
IGR is a crucial ratio to determine the potential that a company holds. What makes this ratio effective is that it is based on two very crucial metrics. The first is the asset turnover ratio, and the second is the retention ratio. Both these metrics themselves are excellent indicators of the financial health of a company.
Quiz on Internal Growth Rate
This quiz will help you to take a quick test of what you have read here.