Internal Growth Rate (IGR) is a financial metric that measures the maximum growth rate that a company can achieve using only its existing resources, without requiring any additional external financing. It is an important metric for businesses to track, as it provides insight into the company’s ability to generate growth and profitability without the need for external financing.
In this article, we will define Internal Growth Rate, discuss its uses, provide the formula to calculate it, and give an example of how to use it.
Definition of Internal Growth Rate
The Internal Growth Rate is the maximum rate at which a company can grow using only its existing resources. It assumes that the company will not issue any additional equity or debt, and will instead rely solely on its internal resources to finance growth. The IGR is often used as a benchmark to assess a company’s ability to grow and generate profits without relying on external financing.
Uses of Internal Growth Rate
The IGR can be used by businesses for a variety of purposes, including:
- Setting growth targets – The IGR provides a realistic benchmark for businesses to set growth targets. By understanding the maximum rate of growth that can be achieved using only existing resources, businesses can set realistic targets and allocate resources accordingly.
- Assessing financial health – The IGR can also be used to assess a company’s financial health. If the IGR is high, it indicates that the company is generating enough internal cash flow to finance growth without relying on external financing. On the other hand, a low IGR may indicate that the company is heavily reliant on external financing and may be at risk of financial distress.
- Identifying opportunities for investment – The IGR can help businesses identify opportunities for investment. By understanding the maximum rate of growth that can be achieved using only existing resources, businesses can identify areas where they can invest to increase their IGR.
Formula to Calculate Internal Growth Rate
The formula to calculate the Internal Growth Rate is as follows:
IGR = (ROA x b) / (1 – ROA x b)
Where:
ROA = Return on Assets
b = Retention ratio (1 – dividend payout ratio)
Return on Assets is calculated by dividing net income by total assets. The retention ratio is calculated by subtracting the dividend payout ratio from 1.
Example Calculation
Let’s say a company has a net income of $1 million, total assets of $10 million, and a dividend payout ratio of 30%. The Return on Assets (ROA) would be calculated as:
ROA = Net income / Total assets
ROA = $1 million / $10 million
ROA = 0.1 or 10%
The retention ratio would be calculated as:
Retention ratio = 1 – Dividend payout ratio
Retention ratio = 1 – 0.3
Retention ratio = 0.7 or 70%
Using these figures, the Internal Growth Rate would be calculated as:
IGR = (ROA x b) / (1 – ROA x b)
IGR = (0.1 x 0.7) / (1 – 0.1 x 0.7)
IGR = 0.07 / 0.93
IGR = 0.0753 or 7.53%
This means that the company’s maximum growth rate using only existing resources is 7.53% per year.
Limitations of Internal Growth Rate
While the Internal Growth Rate is a useful metric for assessing a company’s ability to generate growth without relying on external financing, it has some limitations. For example, it assumes that the company will maintain the same level of profitability and asset efficiency going forward. It also does not take into account external factors that may impact growth, such as changes in the economy or industry.
The Internal Growth Rate is an important metric for businesses to track as it provides insight into the company’s ability to generate growth and profitability without relying on external financing. By understanding the maximum rate of growth that can be achieved using only existing resources, businesses can set realistic targets, assess their financial health, and identify opportunities for investment. The formula to calculate the IGR is straightforward and easy to use, and it can be used in a variety of industries and business types.
However, it is important to keep in mind that the IGR has some limitations, and it should not be the only metric used to assess a company’s financial health. Other factors, such as external market conditions, industry trends, and management strategies, should also be taken into account. Overall, the IGR is a useful tool for businesses to assess their internal growth potential and make informed decisions about their financial future.
