Internal growth rate

What Is Internal Growth Rate?

The internal growth rate is the maximum rate at which a company can grow its revenues and assets without needing to raise external debt financing or equity financing. This metric falls under the umbrella of corporate finance, specifically within financial planning and analysis. It indicates a company's ability to expand purely through its internally generated funds, relying solely on retained earnings. The internal growth rate essentially reflects how much a company can grow if it reinvests all of its profits and does not issue new shares or take on additional debt. It is a key measure of a firm's self-sufficiency in funding its expansion.

History and Origin

The concept of internal growth, and the calculation of the internal growth rate, emerged as businesses sought to understand their capacity for self-funded expansion. Early financial analysis focused on a company's ability to fund its growth through operational profits rather than relying heavily on external capital markets. This became particularly pertinent during periods when access to credit was restricted or costly, or when companies preferred to maintain low levels of financial leverage. The idea is rooted in the principle that a company's long-term viability and independence can be enhanced by its ability to generate sufficient funds for its own reinvestment needs. Corporate profits are a primary source of funding for capital investments that increase productive capacity, as highlighted by the Bureau of Economic Analysis.⁴

Key Takeaways

• The internal growth rate measures the maximum growth a company can achieve without external funding.
• It assumes all profits not distributed as dividends are reinvested.
• This rate relies on the company's profitability and how efficiently it uses its assets.
• A higher internal growth rate suggests a greater capacity for self-funded expansion.
• It is a theoretical maximum, as few companies solely rely on internal funding for sustained, significant growth.

Formula and Calculation

The internal growth rate (IGR) is calculated using a company's return on assets (ROA) and its retention ratio. The retention ratio is the proportion of net income that a company retains and reinvests in the business, rather than paying out as dividends.

The formula for the internal growth rate is:

Where:

• ROA (Return on Assets) is calculated as Net Income / Total Assets. This measures how efficiently a company uses its assets to generate earnings.
• Retention Ratio is calculated as (Net Income - Dividends) / Net Income, or 1 - Dividend Payout Ratio. This represents the portion of earnings kept by the company for reinvestment.

For example, if a company has an ROA of 10% and a retention ratio of 60% (meaning it reinvests 60% of its net income), its internal growth rate would be:

Interpreting the Internal Growth Rate

The internal growth rate provides insight into a company's capacity for growth through organic means. A higher internal growth rate suggests that a company can expand more significantly without diluting ownership or increasing its debt burden. It reflects the strength of a company's operations and its ability to generate sufficient cash flow for reinvestment. Investors and analysts use the internal growth rate to assess a company's financial independence and its potential for growth in the absence of external capital injections. It is particularly relevant for companies operating in mature industries or those with limited access to capital markets. However, it's important to remember that this is a theoretical maximum and rarely represents actual growth targets, as most growing businesses utilize some form of external capital. The use of internal funds for investment vs. shareholder payouts like dividends and buybacks is a constant area of focus in corporate finance.³

Hypothetical Example

Consider "InnovateTech Inc.", a software company that generated $10 million in net income last year. Its total assets are $50 million, and it distributed $2 million in dividends to shareholders' equity.

1. Calculate ROA:
   ROA = Net Income / Total Assets = $10,000,000 / $50,000,000 = 0.20 or 20%
2. Calculate Retention Ratio:
   Retained Earnings = Net Income - Dividends = $10,000,000 - $2,000,000 = $8,000,000
   Retention Ratio = Retained Earnings / Net Income = $8,000,000 / $10,000,000 = 0.80 or 80%
3. Calculate Internal Growth Rate:
   IGR = (ROA × Retention Ratio) / (1 - (ROA × Retention Ratio))
   IGR = (0.20 × 0.80) / (1 - (0.20 × 0.80))
   IGR = 0.16 / (1 - 0.16)
   IGR = 0.16 / 0.84 ≈ 0.1905 or 19.05%

InnovateTech Inc. has an internal growth rate of approximately 19.05%, meaning it could theoretically grow its assets and revenues by that much using only its retained earnings without seeking outside funding.

Practical Applications

The internal growth rate is a valuable tool in financial analysis and strategic planning. Companies often use it to:

• Assess self-sufficiency: It helps management understand how much growth can be sustained without external capital, guiding decisions on working capital management and operational efficiency.
• Evaluate reinvestment policies: The rate underscores the impact of dividend policies on growth capacity; a higher retention ratio (less dividends paid) generally leads to a higher internal growth rate.
• Benchmark performance: While not a target in itself, it can be compared to historical rates or industry averages to understand a company's organic growth potential relative to its peers.
• Inform capital budgeting: It helps frame the scale of projects a company can undertake with internally generated funds before considering external financing.

The ability of companies to fund business investment can be influenced by broader economic conditions and monetary policy, which can impact the "new normal" for economic growth.

L²imitations and Criticisms

While useful, the internal growth rate has several limitations:

• Assumes no external financing: It rigidly assumes that a company will not raise any new debt or equity, which is often unrealistic for rapidly growing firms. Most expanding companies utilize a mix of internal and external capital.
• Ignores capital structure changes: The model doesn't account for changes in a company's capital structure, such as varying levels of debt relative to shareholders' equity, which can significantly impact growth potential.
• Static snapshot: It is based on historical data (ROA and retention ratio) and may not accurately predict future growth if these underlying metrics change.
• Focus on assets, not sales: While related to sales growth, the internal growth rate is primarily a measure of asset growth, which may not directly translate to desired revenue growth without changes in asset turnover.
• May discourage optimal capital allocation: An overemphasis on purely internal growth might lead a company to forgo potentially value-creating projects that would require modest external funding but offer higher returns. Some analyses suggest that market incentives sometimes favor shareholder distributions like dividends and share buybacks over long-term productive investment.

I¹nternal Growth Rate vs. Sustainable Growth Rate

The internal growth rate is often confused with the sustainable growth rate (SGR), but there is a key distinction.

The sustainable growth rate provides a more realistic view of a company's long-term growth capacity because it acknowledges that businesses can and often do utilize external debt to finance expansion while maintaining their desired capital structure.

FAQs

What does a high internal growth rate indicate?

A high internal growth rate suggests that a company is highly profitable and efficient in using its assets, allowing it to generate substantial retained earnings for reinvestment. This indicates a strong capacity for self-funded expansion without relying on outside capital.

Can a company's actual growth exceed its internal growth rate?

Yes, a company's actual growth can, and often does, exceed its internal growth rate. This occurs when the company raises external debt financing or issues new equity financing to fund its expansion. The internal growth rate represents a theoretical ceiling if growth were to be funded solely from within.

Why is retained earnings crucial for internal growth?

Retained earnings are crucial because they are the only source of funding for the internal growth rate. Without these accumulated profits that are reinvested back into the business, a company would have no internal capital to fund its expansion and would be entirely dependent on external sources.