Internal growth rate (IGR) is the measure of the growth of a business without external financing. It is driven by the net income and retained earnings of a business.
Let us discuss what is IGR and how to calculate it.
What is Internal Growth Rate?
Internal growth rate (IGR) is the level of growth achieved without using external financing like debt. It is the growth rate that a business or investment can produce using internal resources.
In business terms, it is the sales growth supported by the core operations of a business without issuing more stocks (Equity) or bonds (Debt).
As such the internal growth is supported by profits and retained earnings of a business. The IGR is then the maximum rate that a business or an investment can achieve using these resources.
In other words, the internal growth rate is the measure of a business’s ability to grow without relying on external financing. It is important for startups and investment appraisals in many ways.
How to Calculate Internal Growth Rate?
The internal growth rate links the return on assets (ROA) to the retention ratio of the business.
We can calculate IGR by using the following formula:
Internal Growth Rate = (ROA×R)/1−(ROA×R)
ROA = Return on Assets R= Retention Rate
Retention Rate = Reinvested Earnings/Net Income = 1- Dividend Payout Ratio
You can use the earnings per share and dividend per share figures to calculate the retention ratio as well.
You can calculate the IGR of a business with these steps.
The first step is to calculate the return on assets of the business. It is the net income divided by the total average assets of the business.
You should use these figures for the same accounting period. Here you can use the end-of-the-year asset values.
The second step here is to calculate the retention ratio of the business. It is the ratio at which the business retains its net income after distributing dividends to its shareholders.
The retention ratio is calculated by dividing the net income minus dividends figure by the net income for the year. Or simply it is one minus dividend payout ratio of the business.
Note: If a business does not pay dividends for the year, its retention ratio will be 100% and if it pays out all of its profits in dividends, its retention ratio will be 0%.
Once you have both these figures from the first two steps, you can now easily use the IGR formula to calculate the IGR of the business for the given period.
Suppose we have the following data available for ABC company. We can calculate the IGR for ABC company using the formula and steps outlined above.
Net Income = $ 450,000 Average Total Assets (Year-End) = $ 1,800,000
Dividends = $ 230,000
Return on Assets = Net Income/Average total Assets
Return on Assets = $450,000/$1,800,000 = 0.25 or 25%
Retention Ratio = Reinvesting income/Net Income
Retention Ratio = ($450,000 – $230,000)/$450,000 = 0.488 0r 48.8%
Now we can use these two figures to calculate the IGR of ABC company for the year.
Internal Growth Rate = (ROA ×R)/1- (ROA×R)
Internal Growth Rate = (0.25 × 0.488)/1- (0.25 × 0.488)
Internal Growth Rate = 0.122/0.878 = 0.1396 0r 13.96%
Understanding Internal Growth Rate
The internal growth rate is the measure of the ability of a company to support its growth needs using internal resources.
The quantification of internal resources is often translated into profits. Then, the business has a choice to distribute these profits to its shareholders or reinvest them for growth.
Both decisions are mutually exclusive as the business cannot fulfill both objectives using the same amount. Net income can either be retained or issued in the form of dividends.
Thus, a business must compare the opportunity costs when deciding on one by forgoing the second option.
Then, there are a couple of important assumptions that derive from the IGR. The first is to consider the same growth rate for all financial metrics of the business.
For example, you should consider the same growth rates for total net assets, operating expenses, interest rates, and other financial metrics.
The second one is that the retention ratio remains constant for one accounting period and the accounts payable of the business do not grow. It means the company reinvests all profits after issuing the dividends.
Similarly, when analyzing the IGR, we should consider that it depends on ROA and the retention ratio of the business.
Return on assets then depends on the efficient utilization of the assets and by comparing the net income against the total net value of these assets.
Again, the retention ratio will largely depend on the net income. Then, the decision to announce dividends or retain profits will decide the retention ratio.
Thus, we can see that IGR can be manipulated somehow by changing the accounting policies affecting the net value of assets and dividends.
Importance of the Internal Growth Rate
The internal growth rate of a business is the direct reflection of internal efficiency. The better a business utilizes its internal resources the higher its IGR goes.
The efficiency is driven by the effective use of assets. If the business generates more sales with the available resources, it increases the efficiency level.
For example, the company can maximize its bottleneck resources such as labor and machine hours to maximize its production and generate more sales.
Then, it’s important to know that a business can keep all or part of the net income for reinvestment.
Thus, the IGR is directly linked to the dividend decision as well. Businesses can keep a constant dividend payout ratio and link it with net income growth.
Businesses cannot survive without debt financing in the long term though. Debt financing reduces the total cost of capital of a business.
However, the IGR compares the performance of a business in the absence of external financing. Thus, it can be used to compare the performance of a business with and without debt financing.
In practice, when a business is using debt financing, it’s difficult to differentiate between external and internal resources already being utilized by the business.
How to Improve the Internal Growth Rate?
The IGR depends on two factors as we can see in its formula: ROA and the retention ratio.
Therefore, when a business improves both of these metrics, it can improve its IGR.
The first driver of the IGR is the ROA. When the return on assets increases, the net income of the business increases. That in turn means increased retained earnings.
The second metric is the retention ratio. When the retention ratio increases, the dividend payout ratio decreases. Thus, the IGR of the business increases.
Collectively both of these metrics are driven by the net income of the business. The higher the revenue and lower the running costs, the higher the IGR of the business.
Strategies for Internal Growth
Apart from these quantitative metrics, a business can use different strategies to boost its internal growth rate.
Increased production can be achieved with higher operational efficiency. It means the efficient use of labor, machinery, and raw materials.
Optimizing the limited resources without compromising the production quality leads to higher revenue and net income.
If the business has available resources, it can increase the production level by simply converting raw materials into finished goods more quickly.
New Line of Products
Introducing new products or a new line of products is a risky decision for any business. However, it is an effective way of generating more revenue and diversifying the risks.
Developing new products is a high-cost but high-reward strategy. It helps a business target a new customer base and attract more sales.
Entering New Markets
If a business cannot introduce new products in the existing market, it must enter the new markets with existing products.
Market expansion is viable for businesses with generic products and where product differentiation is difficult.
Depending on your product or service, you can enter new states, countries, or regions to expand the market share.
Increasing the Current Customer Base
Increasing the current customer base means expanding the market share in the existing market.
It can be done by extensive market research and increasing marketing efforts. For instance, offering a special discount on a certain product to attract more customers.
Increasing the current market share is a useful strategy for internal growth.
Diversifying Business Income
An expensive but highly effective internal growth strategy is the diversification of the business income.
It can be achieved by introducing a new business segment or introducing an unrelated line of business using the available resources.
This strategy is challenging in many ways as it is time-consuming and costly but it is highly effective for the internal growth of a business.