Calculate Internal Growth Rate

Introduction

Understanding the internal growth rate of a business is crucial for assessing its organic expansion capabilities without the need for external financing. This calculation helps business managers and investors gauge the maximum growth achievable from reinvested earnings alone. Calculating the internal growth rate involves analyzing retained earnings and the company's overall profitability.

In this guide, we delve into the methods and components essential for calculating the internal growth rate accurately. We will also explore how Sourcetable facilitates this process and more with its AI-powered spreadsheet assistant. You can try it yourself at app.sourcetable.com/signup.

How to Calculate Internal Growth Rate

The Internal Growth Rate (IGR) is a crucial metric for analyzing a company's potential to grow using only its retained earnings. Understanding how to compute the IGR effectively allows businesses and investors to assess the self-funded growth prospects without external capital.

Key Components Needed for Calculation

To calculate the IGR, you need two primary financial metrics: the Retention Ratio and the Return on Assets (ROA). The formula for IGR is IGR = Retention Ratio \times ROA.

Calculating Retention Ratio

The Retention Ratio represents the part of net income not distributed as dividends but retained for reinvestment. It is calculated using the formula Retention Ratio = (Net Income - Dividends) / Net Income. Alternatively, it can be computed as Retention Ratio = 1 - Dividend Payout Ratio.

Calculating Return on Assets (ROA)

ROA measures how effectively a company uses its assets to generate net income. Calculate ROA by the formula ROA = Net Income / Average Total Assets.

Executing the IGR Calculation

Once the Retention Ratio and ROA are determined, multiply these two figures to find the Internal Growth Rate: IGR = Retention Ratio \times ROA. This calculation reveals the maximum growth rate achievable through reinvestment of retained earnings alone.

By maintaining precise data on net income, dividends, and total assets, companies can apply these calculations to strategize their financial planning and growth trajectory effectively.

How to Calculate Internal Growth Rate

The internal growth rate (IGR) is a vital metric for assessing a company's ability to expand using only its retained earnings, without the need for external financing. This rate is critical especially for smaller businesses and startups aiming to understand their self-sustained growth potential.

Step 1: Calculate the Retention Ratio

To commence the calculation, first determine the retention ratio using the formula Retention Ratio = (Net Income - Dividends) / Net Income. This ratio signifies the percentage of net income retained after paying out dividends, which is reinvested in the company.

Step 2: Calculate Return on Assets (ROA)

Next, calculate the return on assets by applying the formula ROA = Net Income / Average Total Assets. Here, the average total assets are typically calculated by summing the asset balances at the beginning and end of the period, then dividing by two.

Step 3: Compute Internal Growth Rate

Finally, multiply the retention ratio by the return on assets to find the IGR using IGR = Retention Ratio * ROA. This result reveals the maximum sales growth rate the company can achieve using its internal resources only.

Understanding and calculating the internal growth rate enables companies to plan effectively for sustainable growth without relying on external financial sources like debt or new equity.

Examples of Calculating Internal Growth Rate

Example 1: Basic Calculation

To calculate the Internal Growth Rate (IGR), use the formula: IGR = (Return on Assets * Retention Ratio) / (1 - (Return on Assets * Retention Ratio)). Suppose a company has a Return on Assets (ROA) of 8% and a retention ratio of 50%. The calculation would be IGR = (0.08 * 0.50) / (1 - (0.08 * 0.50)) = 0.04 / 0.96 = 0.0417 or 4.17%.

Example 2: Zero Retention Ratio

When a company pays out all its earnings as dividends, the retention ratio is 0. The formula simplifies as IGR = (ROA * 0) / (1 - (ROA * 0)) = 0. For example, with an ROA of 10%, IGR would be 0%, indicating no growth from retained earnings.

Example 3: High Retention Scenario

If a company has a very high retention ratio and a moderate ROA, the internal growth rate can be significant. With an ROA of 12% and a retention ratio of 90%, the IGR is calculated as IGR = (0.12 * 0.90) / (1 - (0.12 * 0.90)) = 0.108 / 0.892 = 0.121, which equals 12.1%.

Example 4: Impact of Increasing ROA

Improving operational efficiency increases ROA, which can significantly impact IGR. For an initial ROA of 5% and retention ratio of 60%, the IGR is IGR = (0.05 * 0.60) / (1 - (0.05 * 0.60)) = 0.03 / 0.97 = 0.0309 or 3.09%. If ROA improves to 7%, IGR increases to IGR = (0.07 * 0.60) / (1 - (0.07 * 0.60)) = 0.042 / 0.958 = 0.0438 or 4.38%.

Example 5: Comprehensive Example

Consider a company with a ROA of 15%, a retention ratio of 70%, and estimated future earnings growth impacting both parameters. Initially, the IGR is IGR = (0.15 * 0.70) / (1 - (0.15 * 0.70)) = 0.105 / 0.895 = 0.1173 or 11.73%. With improvements in operational efficiencies leading to a ROA increase to 18%, the new IGR is IGR = (0.18 * 0.70) / (1 - (0.18 * 0.70)) = 0.126 / 0.874 = 0.1442 or 14.42%.

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Conclusion

Understanding how to calculate the internal growth rate is crucial for any business looking to measure its organic growth potential without additional financial leverage. The calculation involves using the retention ratio and return on assets for a specific period. Specifically, the internal growth rate formula is IGR = ROA * b / (1 - ROA * b), where ROA stands for return on assets and b is the retention ratio (1 - dividend payout ratio).

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