Internal Growth Rate (or IGR) is the maximum growth rate that the company is confident of achieving without having to obtain funding from outside. This is the growth rate at which the company assumes it would continue to grow the business and run the 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 as 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 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 as it talks about the firm’s capability to increase sales and profit without issuing any further equity or debt. Thus, an analyst comparing IGR of two companies will always prefer the one with a higher IGR.
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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.
Retention ratio, on the other hand, 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 for internal growth rate – Retention ratio x ROA or (1- Dividend payout ratio) x ROA.
Assumptions for Calculating Internal Growth Rate
- The dividend payout ratio should be as per the targeted rate.
- Sales and assets are related proportionally. Meaning an increase in the sales would cause an increase in the assets in direct proportion.
- A company does not raise funds in the form on equity capital or debt.
- To achieve the IGR, the firm must finance all additional funding requirements from the retained profits.
- PAT or profit after tax should be in directly proportional to the revenue.
A company earned $15 million last year, and of which, it paid 60% in the form of dividends. The total asset for the company is $100 million, and equity totals $40 million.
To calculate IGR, we should know the return on assets and retention ratio or the dividend payout ratio. Since we know dividend payout in this case, the next step would be to calculate Return on Assets (ROA). ROA here would be 20 million/100 million = 20%.
Now that ROA is 20% and payout ratio is 60%, the internal growth rate would be (1-60%) x20% = 8%. It is clear from the above calculation that the company would be able to achieve sales and assets growth of 8% without relying on any form of external funding.
Investors, on the other hand, might not be happy with just 8% growth. Therefore, management might decide to raise finance from external sources to increase the growth rate. If the organization chooses to raise the money but ensures to maintain the same debt ratio as it currently has, it would help them to achieve the growth rate up to the sustainable growth rate.
Sustainable growth rate calculation requires the retention ratio and return on equity (ROE). Return on equity in this case would be $15 million/ $40 million = 37.5%. Thus, sustainable growth rate would be (1-60%) x 37.5% =15%.
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 the sustainable growth from a shareholders return creation and profitability point of view, irrespective of the company’s financial plans.
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 a 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.
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. First is the asset turnover ratio, and the second is the retention ratio. Both these metrics themselves are an excellent indicator of the financial health of a company.1–3