What is Internal Growth Rate Formula?

The internal growth rate is the rate of growth that the company can attain only with the help of its internal operation. It is the growth rate attained by the company without taking into effect the impact of anyFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more financial leverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more in the form of debt funding. The formula for calculating the internal growth rate is the company’s ROA multiplied by the ROAROAReturn on assets (ROA) is the ratio between net income, representing the amount of financial and operational income a company has, and total average assets. The arithmetic average of total assets a company holds analyses how much returns a company is producing on the total investment made.read more of the company multiplied by the retention ratioRetention RatioRetention ratio indicates the percentage of a company’s earnings which is not paid out as dividends but credited back as retained earnings. This ratio highlights how much of the profit is being retained as profits towards the development of the firm.read more of the company. Return on assets for a company is calculated by the company’s net income divided by the company’s total assets.

Total assets include all the short-term and long-term assets of the company, which the company acquires and deploys to run and expand its business operation. The retention ratio is the percentage of earnings that the company retains for its use and future growth. The retention amount is the residual amount after the amount paid from earnings as a dividend.

Mathematically, it is represented as,

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Where

  • ROA= Return on AssetsRR= Retention ratio

Explanation

This ratio signifies for a company how much the company can grow sustainably in the future with the number of earnings it generates with the help of the normal course of business. It is the operational growth rate achieved without considering the borrowed funds in the form of debt by the company. This ratio is considered to be internal as this much the company will be able to grow even without taking any outside debt investments.

It is the growth achieved by a company with the help of the earnings it decides to retain after distributing the amount of money to the shareholders in the form of a dividend. An analyst looking at this ratio will look for a higher ratio as it signifies a better prospect for the company.

Examples of Internal Growth Rate Formula (with Excel Template)

Let’s see some simple to advanced examples to understand this ratio better.

Example #1

Let us calculate the internal growth rate for two arbitrary companies. For the calculation, we need a company’s return on assets and a retention ratio, which is calculated by deducting the dividend amount payableDividend Amount PayableDividend payable is that portion of accumulated profits that is declared to be paid as dividend by the company’s board of directors. Until the dividend declared is paid to the concerned shareholders, the amount is recorded as a dividend payable in the head current liability.read more from the company’s earnings and dividing that numerator by the net income available to the shareholders.

Let’s assume some numbers in the table below for two companies.

For the calculation of internal growth rate first, calculate the following value,

Retention Ratio for Company A

  • Retention Ratio (RR) = 1- (dividends paid/earnings)=1-(3/5)=0.40

Retention Ratio for Company B

  • Retention Ratio (RR) =1-(3.5 / 6)=0.42

Return of Assets for Company A

  • Return of Assets = $65/$140=46%

Return of Assets for Company B

  • Return of Assets = $70/$155=45%

Therefore, the calculation for company A is as follows,

  • IGR Formula = 46% * 0.40

Internal Growth Rate for company A

  • IGR = 18.6%

The internal growth rate for company B

  • IGR Formula = 45% * 0.42= 18.8%

We can see from the above example that the growth rate for company B is higher than the internal growth of company A. The internal growth does not consider the effect of the growth from debt funding. It implies that company B can grow through earnings from operations more than company A.

Example #2

To calculate the growth rate of Reliance Industries, we need a return on assets for the company and a retention ratio, which is calculated by deducting the dividend amount payable from the company’s earnings and dividing that numerator by net income available to the shareholders.

The table below depicts the dividend, earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more, and the return on assets for reliance industries.

For the calculation of internal growth rate, first, calculate the following value,

Retention ratio

  • Retention ratio for Reliance Industries = 1- (6/56) =.89

Therefore, the calculation of growth rate of Reliance Industries is as follows,

  • IGR Formula = 8% * 0.89

  • IGR = 7.1%

The higher the growth rate the better it is for the company; the ratio signifies a company that can grow sustainably in the future with the number of earnings it generates with the help of the normal course of business. The ratio for reliance industries signifies that reliance industries can grow by 7.1% with their internalOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business.read more operational incomeOperational IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business.read more.

Example #3

To calculate the growth rate of TATA steel, we need a return on assets for the company and a retention ratio, which is calculated by deducting the dividend amount payable from the company’s earnings and dividing that numerator by net income to the shareholders.

The table below depicts the dividend, earnings per share, and the return on assets for Tata Steel.

Retention Ratio for Tata Steel

  • Retention ratio = 1 – (9.4 / $75)=0.87

Therefore, the calculation of the growth rate of Tata Steel is as follows,

  • IGR Formula =13% * 0.87

The internal growth rate of Tata Steel will be –

  • IGR = 11.4%

Internal Growth Rate Calculator

You can use the following Internal Growth Rate Calculator.

Relevance and Use

This ratio is very important to find out the prospect of a company. Analysts who analyze the company keep a very close look at the ratio. The ratio is arrived at by using two very important parameters: the company’s return on assets. And the second variable used for calculating the internal growth rate is the retention ratio.

Suppose a company is maintaining a higher level of retention ratio. In that case, it signifies that the company has future growth prospects and is confident of generating a higher return with the money it is willing to retain. The internal growth is the rate that the company attains with the help of the earnings it decides to retain.

This article has been a guide to Internal Growth Rate Formula. Here we discuss how to calculate Internal Growth Rate Ratio with simple to advance examples and a downloadable excel sheet. You can learn more about financing from the following articles –

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  • P = D1/r-g (P = stock price, g = constant growth rate, r = rate of return, D1 = value of next year’s dividend)
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