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 any financial leverage in the form of debt funding. The formula for calculating the internal growth rate is the company's ROA multiplied by the ROA of the company multiplied by the retention ratio 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,

Internal Growth Rate Formula = ROA * RR

Where

• ROA= Return on Assets
• RR= Retention ratio

Key Takeaways                                                               

• Internal growth rate is the fastest pace at which a business can expand internally without financial leverage. Multiplying the company's ROA by the retention ratio will get the result. Net income divided by total assets is known as ROA.
• A company's potential for sustainable growth is based on its earnings from regular business activities, without factoring in growth through debt. Higher ratios indicate expansion opportunities without external debt investments.
• Analysts monitor a crucial ratio to determine a company's prospects, calculated using the return on assets and retention ratio. The latter factor helps determine the internal growth rate.

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.

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 payable 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 share, 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 internal operational income.

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.

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

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%

You can use the following Internal Growth Rate Calculator.

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.