Internal growth rate

What is Internal growth rate ?

The internal growth rate of a firm is the maximum rate of growth it can achieve using its Internal sources of funds without any reliance being place on external funding. It is the rate of growth a firm manages to achieve without external funds in the form of Debt or Equity. It is a growth rate obtained by means of using its retained earnings remaining after paying the amount of dividend due, if any.


What is the relevance of Internal growth rate ?

It is an indicator of sales growth potential of a firm. A high internal growth rate shows that a company can sustain itself without any dependence on any external source of funds. It is able to generate sufficient funds to run its operations by itself. 

If a firm has a low internal growth rate, it means that funds generated from its existing operations are insufficient to run the business. It needs or is employing external funding in the form of debt or equity, as the case may be. Any form of external funding comes with a set of given costs. These costs will reduce the profits of the company. It is always advised that a firm focuses on maintain a steady rate of Internal growth commensurate with its business needs.

The Internal growth rate performance as a parameter is more relevant in the context of start up firms. A high internal growth rate means that a company is able to generate sales and expand its operations without the additional cost of external funding.

 

What is the internal growth rate formula ?

The formula for calculating the internal growth rate is arrived at by multiplying the Return on assets with Retention ratio of a firm.

 IGR = ROA * Retention ratio

Where  IGR = Internal growth rate  ;  ROA = Return on assets   ;  Retention ratio = ( 1 – Dividend payout ratio )

Thus the IGR can also be written as

IGR = Return on Assets * ( 1 – Dividend payout ratio )

 

It is noticeable here that as the retention ratio decreases, the Internal growth rate also decreases. As a result, there will a flow of funds from external sources. An increasing retention ratio results in an increase in Internal Growth rate, due to usage of existing retained earnings available with the firm to drive sales growth.

Similary, an increase in the Return on assets implies an increased Internal growth rate.


What is the difference between internal growth rate and sustainable growth rate ?

Sustainable growth is the maximum growth rate that a firm can achieve using its retained earnings and allowing addition of only that proportion of external debt, that would maintain the exiting the debt equity ratio. Thus, no equity financing is permissible in calculation of sustainable growth rate.

Whereas Internal growth rate is based on the retained earnings of the firm, devoid of any form of external financing, neither in the form of debt nor equity.

 

Example 1 :

Woodswitch Inc. has reported a Return on Assets of 20 %, Return on equity of 17 % and a Retention ratio of 75 % for the current year. What is its internal growth rate ? ( Round the solution to two decimal places )

Solution :

As per the information provided in the question we have

Return on Assets = 20 %     ;    Retention ratio = 75 % = 0.75    ;

 

Applying the above values in the formula we have internal growth rate as

= 20 % * 0.75

= 15 %

Thus Woodswitch Inc.’s internal growth rate = 15 %

 

Example 2 :

Brunswitch Inc. has reported a Return on Assets of 20 %, Return on equity of 17 % and a Divided payout ratio of 30 % for a given year. Calculate the internal growth rate for the said year ? ( Round the solution to two decimal places )

Solution :

As per the information provided in the question we have

Return on Assets = 20 %   ;    Dividend payout ratio = 30 % = 0.30    ;

 

Applying the above values in the formula we have internal growth rate as

= 20 % * ( 1 – 0.30 )

= 20 % * 0.70 = 14 %

Thus Brunswitch Inc.’s internal growth rate = 14 %

 

 

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