How to Calculate Internal Growth Rate (IGR) in Finance: Definition, Formula and Example
Internal Growth Rate Definition
The Internal Growth Rate (IGR) measures how much a business can grow using only its internal resources, such as net income and retained earnings, without relying on external financing like issuing new equity or taking on debt.
It answers the question: “How much can a business grow purely by generating profits and reinvesting them?”
The internal growth rate focuses on a company’s ability to fund organic growth – such as starting new projects, expansion or acquiring additional assets – by concentrating on two key areas:
- Profitability: How effectively the business generates profits from its operations, measured by Return on Assets (ROA).
- Reinvestment: The percentage of profits retained for growth rather than being paid out as dividends, measured by the Retention Ratio.
Internal Growth Rate Formula
The formula for calculating the internal growth rate is:
Internal Growth Rate (IGR) = (Return on Assets (ROA) × Retention Ratio) / (1 − (Return on Assets (ROA) × Retention Ratio))
Where:
- Return on Assets (ROA): This measures how efficiently a company uses its assets to generate profit, and is calculated as:
ROA = Net Income / Total Assets
- Retention Ratio: This represents the proportion of profit that is kept in the company rather than paid out as dividends to shareholders, calculated as:
Retention Ratio = (Net Income – Dividends) / Net Income
Or
Retention Ratio = 1 − Payout Ratio
The Payout Ratio is the percentage of earnings paid out as dividends, whereas the Retention Ratio is the percentage of earnings kept within the company.
The formula for the payout ratio is:
Payout Ratio = (Net Income / Dividends Paid) × 100
Calculating the Internal Growth Rate Step-by-Step
Let’s now walk through a step-by-step guide of how to to calculate the internal growth rate of a company:
Step 1: Calculate the Return on Assets (ROA)
The first step is to calculate the company’s Return on Assets using the formula:
Return on Assets = Net Income / Total Assets
Step 2: Calculate the Retention Ratio
The next step is to calculate the Retention Ratio, using either of the formulas:
Retention Ratio = (Net Income – Dividends) / Net Income
Or
Retention Ratio = 1 − Payout Ratio
Where
Payout Ratio = (Dividends Paid / Net Income) × 100
Step 3: Calculate the Internal Growth Rate
Now that we have both the Return on Assets and the Retention Ratio, we can apply them to the internal growth rate formula:
Internal Growth Rate = (Return on Assets × Retention Ratio) / (1 − (Return on Assets × Retention Ratio))
This will give us the internal growth rate as a percentage.
Example Internal Growth Rate Calculation
Let’s now work through an example internal growth rate calculation, using the following financial data:
Net Income | £500,000 |
Total Assets | £2,500,000 |
Dividends Paid | £100,000 |
Step 1: Calculate Return on Assets (ROA)
First, we need to calculate the Return on Assets using the net income and total assets information:
Return on Assets = Net Income / Total Assets
Return on Assets = £500,000 / £2,500,000 = 20% or 0.20
Step 2: Calculate Retention Ratio
Next, we need to calculate the Retention Ratio:
Retention Ratio = (Net Income – Dividends) / Net Income
Retention Ratio = (£500,000 – £100,000) / £500,000
Retention Ratio = 80% or 0.80
Optional: We can also calculate the Retention Ratio using the Payout Ratio:
Payout Ratio = (Dividends Paid / Net Income) × 100
Payout Ratio = (£100,000 / £500,000) × 100
Payout Ratio = 20% or 0.20
Therefore:
Retention Ratio = 1 − Payout Ratio
Retention Ratio = 1 – 0.20
Retention Ratio = 80% or 0.80
Step 3: Calculate Internal Growth Rate
Now we can plug these values to the internal growth rate formula:
Internal Growth Rate = (Return on Assets × Retention Ratio) / (1 − (Return on Assets × Retention Ratio))
Internal Growth Rate = (0.20 × 0.80) / (1 − (0.20 × 0.80))
Internal Growth Rate = 0.16 / (1 – 0.16)
Internal Growth Rate = 0.16 / (1 – 0.84) = 0.1905
Therefore, the company’s internal growth rate is 19.05%.
This means the company can grow at a rate of 19.05% per year using just its internal resources and without needing any external financing.
Why is the Internal Growth Rate Important?
Measuring the internal growth rate is vital for several reasons:
Growth Planning
The internal growth rate helps management determine how fast the company can grow without needing any additional external financing.
By knowing the internal growth rate, this allows the company to forecast expansion more effectively, such as launching new projects, entering new markets, or increasing production capacity.
Understanding this also ensures that the company doesn’t overestimate its growth potential, which could lead to overextension or financial strain.
Financial Health Indicator
A high internal growth rate is a sign of strong financial health and profitability.
A company with a strong internal growth rate is usually able to fund its own growth, showing that it has a solid financial foundation and can weather challenges without the need for external funding.
On the other hand, a low internal growth rate would suggest that a company is struggling to generate enough profits to support its own growth and may therefore need external funding.
Avoiding External Financing
The internal growth rate is an important tool for evaluating whether a company needs to seek external financing through debt or equity.
This is important for businesses looking to avoid the costs and risks associated with borrowing money or issuing new shares.
Managing Risk
Businesses that have to rely on external financing, such as taking on debt or issuing equity, introduces various risks including increased debt payment or dilution of shareholder ownership.
Companies with a strong internal growth rate don’t have to take on these risks and can retain control over their own financial obligations and ownership structure.
What is a Good Internal Growth Rate?
Defining what qualifies as a “good” internal growth rate is subjective and dependant on a few factors:
Industry Standards
High-growth industries like technology might aim for 15-30% growth, while mature industries like utilities may consider 5-10% strong.
Benchmarking to industry averages could help to assess competitiveness.
Company Size and Stage
Smaller businesses and new startups might aim for higher internal growth rates (>15%) to fuel rapid growth and expansion, relying heavily on reinvested earnings.
However, mature companies might target lower internal growth rates (<10%) as they focus on steady, sustainable growth.
Return on Assets and Retention Ratio
A company’s Return on Assets and Retention Ratio are other key factors that impact internal growth rate.
A high return on assets means the company is good at generating income, and a higher retention ratio means more profits are being kept and can be used towards funding internal growth.
Sustainability
A ‘good’ internal growth rate should be sustainable – reflecting reliable, consistent growth rather than erratic fluctuations.
For example, a business growing consistently at 5-7% annually due to improved operational efficiency and constant demand shows a high level of financial stability.
On the other hand, a business reporting a sudden spike of 20% growth followed by a sharp decline may be relying on one-time factors, such as a temporary surge in market demand or aggressive cost-cutting.
This volatility can signal underlying instability or unsustainable business practices.