Internal Growth Rate (IGR)

What is the Internal Growth Rate (IGR)?

The internal growth rate (IGR) refers to the sales growth rate that can be supported with no external financing. As such, the company is funding its operations solely from retained earnings. A company’s maximum internal growth rate is the highest level of business operations that can continue to fund and grow the company.

The internal growth rate is important, particularly for smaller businesses or start-ups, since it measures the company’s ability to increase sales and profit without issuing more stock or debt. Internal growth can be generated by adding new product lines or expanding existing ones, and the growth is achieved to the maximum extent possible within the company’s limitations.

Formula for Internal Growth Rate

Where:

• ROA (Return on Assets) = Net Income / Total Assets
• r (Retention Rate) = Reinvested Earnings / Net Income or 1 – Dividend Payout Ratio

How to Calculate Internal Growth Rate

Before the internal growth rate is calculated, one must first determine the return on assets (ROA) by dividing the net income by the total assets. Then, one must find the retention ratio by dividing the reinvested (or retained) earnings by the net income or by subtracting the dividend payout ratio from the total of 1. Now, the IGR is calculated by dividing the ROA by the retention ratio.

One of the assumptions that must be made when calculating the IGR is to assume that everything grows at the same growth rate. Such an assumption means that total assets, operating expenses, and interest expenses would grow at the growth rate. The retention ratio remains the same, and there are no increases in accounts payable.

Drivers of the Internal Growth Rate

It is important to recognize that the internal growth rate increases under two scenarios:

1. Firstly, if the retention ratio increases or the dividend payout ratio decreases, the IGR increases. There are additional retained earnings present with higher retention, so there are more internal funds to grow.
2. Secondly, IGR will also increase if the return on assets (ROA) increases. Like the first scenario, it leads to additional retained earnings and, subsequently, more internal funds for the company to grow.

What Does the Internal Growth Rate Show?

As mentioned briefly earlier, the internal growth rate shows the maximum sales growth rate that can be supported with no external financing by only relying on retained earnings as funding. The IGR can indicate to companies how they can use their existing resources more efficiently and effectively to generate internal growth. For example, manufacturing companies may look at their production process to optimize the use of machinery and labor hours and reduce any idle time to boost productivity.

Internal growth can be generated by adding new business lines or introducing new products that complement the company’s existing offerings or appeal to the product’s target market. At the same time, the company can also review its existing product lines to see if there are any poorly performing products that may be eliminated in order to better divert resources towards more successful products.

Internal Growth Rate vs. Sustainable Growth Rate

Another concept associated with Internal Growth Rate is Sustainable Growth Rate, which refers to the maximum sales growth rate a company can achieve without external equity financing while using the internally generated funds and borrowing just enough to maintain a constant debt/equity ratio. In other words, external financing is allowed but only in the proportion of its current capital mix.

While the internal growth rate assumes no external financing, the sustainable growth rate assumes that some external financing is used. Still, it is consistent with whatever financial policy the company is already following.

The formula for the sustainable growth rate is similar to the formula for IGR. The main difference is that the return on equity (ROE) is used instead of the return on assets (ROA).

Where:

• ROE (Return on Equity) = Net Income / Total Shareholder Equity
• r (Retention Rate) = Reinvested Earnings / Net Income or 1 – Dividend Payout Ratio

Related Readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA®) certification program for those looking to take their careers to the next level. To keep learning and advance your career, the following resources will be helpful:

• Net Income
• Return on Assets (ROA)
• Startup Valuation Metrics
• Total Addressable Market (TAM)
• See all valuation resources