Internal Growth Rate Formula

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. This is the growth rate attained by the company without taking into effect the impact of any 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 a 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 net income of the company divided by the total assets of the company.

Total assets include all the short term and long term assets of the company which the company acquires and deploys in order 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 of the company. The retention amount is the residual amount after the amount paid from earnings as a dividend.

Mathematically, it is represented as,

Internal Growth Rate Formula = ROA * RR
Internal Growth Rate Formula

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For eg:
Source: Internal Growth Rate Formula (wallstreetmojo.com)

Where

  • ROA= Return on Assets
  • RR= Retention ratio

Explanation

This ratio signifies for a company that how much the company can grow sustainably in the future with the number of earnings it is generated with the help of the normal course of business. It is the operational growth rate achieved without taking into consideration the borrowed funds in the form of debt by the company. That’s why 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 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 future 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.

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

Example #1

Let us do the calculation of the internal growth rate for two arbitrary companies. For the calculation, we need a return on assets of a company and 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 earnings of the company and dividing that numerator by net income available to the shareholders.

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

internal growth rate formula example 1.1

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

Retention Ratio for Company A

internal growth rate formula example 1.2
  • Retention Ratio (RR) = 1- (dividends paid/earnings)
  • =1-(3/5)
  • =0.40

Retention Ratio for Company B

internal growth rate formula example 1.3
  • Retention Ratio (RR) =1-(3.5 / 6)
  • =0.42

Return of Assets for Company A

internal growth rate formula example 1.4
  • Return of Assets = $65/$140
  • =46%

Return of Assets for Company B

internal growth rate formula example 1.5
  • Return of Assets = $70/$155
  • =45%

Therefore, the calculation for company A is as follows,

igr formula example 1.6
  • IGR Formula = 46% * 0.40

Internal Growth Rate for company A

igr formula example 1.7
  • IGR = 18.6%

The internal growth rate for company B

igr formula example 1.81
  • IGR Formula = 45% * 0.42
  • = 18.8%

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

Example #2

For the calculation of the growth rate of Reliance Industries, we need a return on assets for the company and retention ratio, which is calculated by deducting the dividend amount payable from the earnings of the company 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.

igr formula example 2.1

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

Retention ratio

igr formula example 2.2
  • Retention ratio for Reliance Industries = 1- (6/56) =.89

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

igr formula example 2.3
  • IGR Formula = 8% * 0.89
igr formula example 2.4
  • IGR = 7.1%

The higher the growth rate better it is for the company; the ratio signifies for a company that much the company can grow sustainably in the future with the amount of earnings it is generated with the help of the normal course of business. The ratio for reliance industries signifies that reliance industries are able to grow by 7.1% with its internal operational income.

Example #3

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

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

igr formula example 3.1

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

Retention Ratio for Tata Steel

igr formula example 3.2
  • Retention ratio = 1 – (9.4 / $75)
  • =0.87

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

igr formula example 3.3
  • IGR Formula =13% * 0.87

The internal growth rate of Tata Steel will be –

igr formula example 3.4
  • IGR = 11.4%

Internal Growth Rate Calculator

You can use the following Internal Growth Rate Calculator.

ROA
RR
Internal Growth Rate Formula
 

Internal Growth Rate Formula = ROA x RR
0 x 0 = 0

Relevance and Use

This ratio is very important to find out the future 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 return on assets of the company. And the second variable used for calculating the internal growth rate is the retention ratio.

If a company is maintaining a higher level of retention ratio, 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.

Recommended Articles

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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