As an investor, it is important to know the potential that a business holds to fund its growth. The internal growth rate is a measure designed to quantify this. In this article, we explain how to calculate it, use it, and what this metric signifies.
What Is Internal Growth Rate (IGR)?
Internal growth rate is the maximum pace a company can hope to grow if it does not require external financing. It defines the level at which operations can grow without issuing new equity or taking on additional debt.
There are many ways of using an internal growth strategy, such as growing market outcomes, expanding product lines, optimizing resources, etc.
But how can one calculate the internal growth rate and use it to analyze a business? How is it different from a sustainable growth rate? Are there any caveats to applying it?
We will be taking up all this in the sections that follow.
How Is IGR Calculated?
Below is the internal growth rate formula:
IGR= (RoA⋅b)/(1−(ROA⋅b))
Where:
- RoA = Return on assets
- b = Retention Ratio
Confused? Let me explain the terms.
Return on Assets (RoA)
Return on assets is the net income expressed as a proportion of the total assets owned by the firm.
It gives you an idea of how much the company is earning back against its acquired assets.
You can calculate it as follows:
RoA = Net earnings/Average Total Assets
Retention Ratio (b)
This number tells you what proportion of a firm’s earnings is retained by it for reinvestment into the business after paying out dividends.
You can calculate it in two ways:
- 1 – Dividend payout ratio
- Retained Earnings/Net Income
Steps to Calculate Internal Growth Rate
It is a complex formula, so here are the steps you need to complete before plugging the values into the internal growth rate calculator:
- Find out RoA by dividing net income by Average total assets
- Calculate retention ratio as 1- (dividend paid/net income)
- Plug the results (1) and (2) into the formula given earlier.
As the formula shows, the internal growth rate increases in only two ways.
The firm can either grow retained earnings or else improve its return on assets.
Retained earnings can increase through higher sales or lowering of costs, while RoA can only go up with better utilization of existing resources.
We explain what this implies in the next section.
What Does It Mean?
The IGR quantifies the maximum sales growth rate that can be funded by reinvesting earnings into maximizing business efficiency.
There are two ways to grow a business – organically and inorganically.
Inorganic growth uses capital infusion by raising debt or offering additional equity.
In many cases, expansion to new geographies, creation of new product lines, creation of new production capacity, and so on are financed through this mechanism.
Organic growth, on the other hand, focuses on using retained income to generate internal growth.
This can come through enhancing sales, reducing costs, or better utilizing assets.
IGR tells us the potential of a firm to grow purely through such internal recalibrations.
In a way, it depicts how optimally a business is being run.
Difference Between Internal Growth and Sustainable Growth Rate?
The internal growth rate refers to growth with zero additional finance.
Sustainable growth rate assumes, on the other hand, that there is (some bit of) external debt financing available.
The key is that the capital structure (or the ratio of debt to equity in the firm) remains constant when growing debt.
To understand this, you must first know that earnings growth automatically increases equity.
In fact, New Equity = Old Equity + Net Earnings – Dividends.
Hence, some debt can be taken if there are positive retained earnings without changing the Debt: Equity ratio.
Due to this reason, the sustainable growth rate is always slightly higher than the internal growth rate (unless the company is unprofitable).
With the additional debt, the firm can afford to grow a bit faster.
Sustainable growth rate is calculated by replacing RoA in the IGR formula with RoE (Return on Equity).
Examples of Internal Growth?
As mentioned earlier, internal growth can be increased by either enhancing sales, reducing costs or better utilization of assets.
For example, let us take the case of an automobile business that has a booming demand, like electric vehicles.
All it needs to do is to enhance production.
One way to do this is by optimizing the manufacturing process to reduce idle time.
This will grow the number of units produced per second, enhancing the asset utilization of an existing factory line.
Now, take the case of a traditional gas-based car maker struggling for demand.
It might enhance its business by focusing on better marketing outcomes.
For example, it could identify new segments of car buyers and focus its marketing budgets on them.
This will help grow the retained earnings by increasing sales.
There could be several other examples of internal growth, such as adding new product lines, improving cash flow utilization, right-sizing human resources, and so on.
Shortcomings of Using IGR
One of the biggest problems with IGR is that it assumes that profitability, capital structure, and dividend payout ratios will remain constant.
This is not necessarily true.
For example, profitability can increase or decrease through a change in the cost of goods or pricing power in the market.
Similarly, IGR assumes that the capital structure remains constant, but in reality cost of debt can greatly influence how a firm chooses to finance itself.
Again, payout ratios can change as the business becomes more mature and starts offering better dividends to shareholders.
Lastly, the internal growth rate is a lag indicator, which measures growth based on the current structure of earnings and cost structure.
It does not take into account what is likely to happen in the next quarter, even though there might be clear indications for it.
Final Thoughts
The internal growth rate is a good metric to understand potential future growth in business operations purely through internal financing.
A company can grow by improving resource utilization, re-aligning budgets, reducing costs, or better utilizing the earnings they are generating.
There are a few caveats when using IGR, however.
It assumes that factors such as cost of debt, capital structure, and dividend payouts will remain constant. This may not always be true.
Still, it is a good measure of how well a business utilizes its earnings and assets.
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