Internal Growth Rate Formula

Internal Growth Rate Formula (Table of Contents)

Internal Growth Rate Formula
Examples of Internal Growth Rate Formula (With Excel Template)
Internal Growth Rate Formula Calculator

In very simple language, the internal growth rate is the maximum growth rate which company can achieve only by using internal funds (retained earnings). It is the rate of growth for which a company does need external financing and any growth expected beyond that might need to be funded by external capital i.e. by debt or equity. The internal growth rate is a very important parameter for small companies and startups since they can measure their ability to grow their business without seeking external help.

There is another parameter which is related to internal growth rate and that is a sustainable growth rate. Sustainable growth rate assumes that a company growth rate which can be achieved by maintaining its existing capital structure i.e. current mix of debt and equity. So as far as we are keeping the mix same, we can source for external financing and that is the reason sustainable growth rate is higher than the internal growth rate. Another difference between internal growth rate and sustainable growth rate is that Internal growth rate takes into account Return on Assets which sustainable growth rate use Return on Equity.

Formula to calculate the Internal Growth Rate is:

Internal Growth Rate = Retained Earnings / Total Assets

Internal Growth Rate = (Retained Earnings / Net Income) * (Net income / Total Assets)

Internal Growth Rate = Retention Ratio * ROA

Retention Ratio is the rate of earnings which a company reinvest in its business. In other words, once all the dividend etc. is paid to shareholders, the left amount is the retention rate.

Retention Ratio = 1 – Dividend Payout Ratio

Formula to calculate the Return on Asset is:

ROA = Net Income / Total Assets

Examples of Internal Growth Rate Formula (With Excel Template)

Let’s take an example to understand the calculation of Internal Growth Rate in a better manner.

You can download this Internal Growth Rate Formula Excel Template here – Internal Growth Rate Formula Excel Template

Internal Growth Rate Formula – Example #1

Consider a small scale listed company X’s which is a wholesale dealer of spare parts. Calculate the internal growth rate using the below information.

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Solution:

Dividend Payout Ratio is calculated using the formula given below

Dividend Payout Ratio = Dividends Paid / Net Income

Dividend Payout Ratio = $4 / $20
Dividend Payout Ratio = 20%

Retention Ratio is calculated using the formula given below

Retention Ratio = 1 – Dividend Payout Ratio

Retention Ratio = 1 – 20%
Retention Ratio = 80%

ROA is calculated using the formula given below

ROA = Net income / Total Assets

ROA = $20 / $200
ROA = 10%

Internal Growth Rate is calculated using the formula given below

Internal Growth Rate = Retention Ratio * ROA

Internal Growth Rate = 80% * 10%
Internal Growth Rate = 8%

Internal Growth Rate Formula – Example #2

I have taken IBM as Target Company for which we need to calculate the internal growth rate. Below is the extract of their financial statements for 2018:

Solution:

Retention Ratio is calculated using the formula given below

Retention Ratio = 1 – Dividend Payout Ratio

Retention Ratio = 1 – 65.30%
Retention Ratio = 34.70%

ROA is calculated using the formula given below

ROA = Net income / Total Assets

ROA = $8,728,000 / $123,382,000
ROA = 7.07%

Internal Growth Rate is calculated using the formula given below

Internal Growth Rate = Retention Ratio * ROA

Internal Growth Rate = 34.70% * 7.07%
Internal Growth Rate = 2.45%

Explanation

Any business can generate good internal growth rate if they can use their resources in an efficient manner. When we say efficient manner, it means that the company should try to maximize its efficiency is utilizing the resources and minimize the waste and idle period. The main driver for the internal growth rate is the reinvestment earnings. If a company can make its operations efficient thereby increasing its profits and reinvesting those profits to grow, the company can achieve a very good internal growth rate of return.

Every business wants to grow and achieve new heights. So every company wants to achieve sustainable growth rate but there are some limitation and headwinds which can stop a business from growing and achieving its sustainable growth rate. This is not very commonly used because of the fact that a company cannot keep on growing with its internal funds and they eventually need external financing to achieve greater heights. So the company can decide its target ratio for debt and equity and using that ratio, the growth rate which they can achieve is the sustainable growth rate.

Relevance and Uses of Internal Growth Rate Formula

Internal growth rate, as discussed above, assumes that a company will not choose any external financing and will growth internal and that growth rate is the internal growth rate. Companies can improve their operations and increase efficiency in using the resources to maximize the internal growth rate. For companies, it is really difficult to sustain high internal growth rate and they have to go for financing at some stage.fsa

In a nutshell, the internal growth rate is one of the key parameters which businesses need to analyze and take into consideration which analyzing their internal growth potential but companies can choose for external financing if they have a good project in hand which can help them in achieving greater heights.