What is internal growth rate (IGR)?
Internal growth rate (IGR) is the highest level of growth a company can achieve without external financing, and a company's maximum internal growth rate is the highest level of growth a company can achieve by continuously funding the company to grow. This is the level of management.
- Internal growth rate (IGR) is the highest level of growth a business can achieve without external financing.
- A company's maximum internal growth rate is the level of business operations that allows the company to grow by continuously providing capital without issuing new equity or debt.
- You can generate internal growth by adding new product lines or expanding existing product lines.
IGR formula and calculation
To calculate a company's internal growth rate, two variables must be determined. First, you need the company's return on assets (ROA). This is:
Net income ÷ Total assets (or average of total assets over period)
Next, we need the retention rate (RR), which is the percentage of how much net income the company retains.
Retained earnings ÷ Net income
Finally, you can calculate your IGR.
Return on total assets x retained earnings rate
So, imagine that Company A's financial statements contain the following data:
- Net income: $30,843,000
- Total assets (or average total assets over all periods): $114,938,000
- Retained earnings: $1,358,000
Using the formula for ROA: $30,843,000 ÷ $114,938,000, it is 0.27. The retention rate ($1,358,000 ÷ $30,834,000) results in 0.04. Next, multiply ROA and RR to find IGR.
0.27 x 0.04 = 0.01, or 10%
You may find other ways to calculate IGR using alternative retention rates. This method subtracts the company's dividend payout ratio from 1.
Retained earnings rate = 1 – dividend payout ratio
However, to use this method, the company must make enough profits to pay the dividend and have a payout ratio (dividends paid ÷ net income). If the dividends paid are zero, the retention rate, or IGR, will be inaccurate. For example, if we used this method with the non-dividend-paying company in the previous example (retention would be zero), the IGR would be 0.27 (27%), whereas previously we would have obtained: 0.01 (10%):
- ROA: 0.27
- RR: 1 – 0 = 1
- IGR: 0.27 x 1 = 0.27, or 27%
Limitations on the use of internal growth rates
Some believe that internal growth rate indicates the maximum growth a company can experience using only existing resources (no external financing, only retained earnings). While this metric can be useful for companies that have reached a point where they can retain profits, it is important to keep in mind that most companies will not be profitable for many years. Without profitability, there may be no retained earnings, which can create additional difficulties if the business owner wants to use her IGR as an analytical tool.
Investors may not see much value in IGR due to the issues mentioned above. The absence of dividends or retained earnings means that interest cannot be calculated. Internal growth may not be a convincing analytical metric, as companies that have retained earnings and pay dividends are generally more mature, having left the startup or small business stage.
Another limitation of IGR is essential to business growth. Retained earnings are capital held in accounts. Companies should not have too much retained earnings because capital is wasted. If a company's retained earnings are increasing, it may mean that its earnings are increasing and it is reinvesting its earnings. It can also mean that the company has capital that it can leverage.
What is the difference between internal growth rate and external growth rate?
Internal growth is when a company grows using internal resources, while external growth is when a company grows using external resources.
Which is higher, the internal growth rate or the sustainable growth rate?
The sustainable growth rate is always higher than the internal growth rate because it takes into account leverage or debt.
What is the formula for calculating internal growth rate?
The formula for calculating the internal growth rate is (retained earnings ÷ net income) x (net income ÷ total assets).
Internal growth rate is a measurement used by some business owners and investors to measure how much growth a business can experience using only internal sources. It can only be used to value companies that are making enough profits to retain profits or issue dividends to shareholders.
Correction—August 24, 2023: A previous version of this article only used the dividend payout ratio to calculate the internal growth rate. As this article correctly states, there are two different ways to calculate it, and you will know when to use each.