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Finance

Internal Growth Rate

The goal of all businesses is to grow. As such owners, management, financiers and investors are all incredibly concerned with tracking the growth of businesses they are linked to. Growth can, of course, be financed from internal sources or external sources or a combination of both. Where growth is funded from internal sources it is measured using the Internal Growth Rate. As we will see this can be calculated from the information contained in the balance of any business though we shall use the example of companies to best drive the point home.

What is Internal Growth Rate?

Internal Growth Rate is the maximum rate of growth in sales and assets that a company can achieve using only retained earnings. If we look at the company income statement, the bottom line gives us the net income or profit for the year. After deducting dividends to shareholders and any transfers to reserves we are left with what is called retained earnings. This is the portion of the profit that remains in the business to be reinvested in their business to earn more profit. Internal Growth Rate gives us a measure of how much a company can grow if only funded from internal sources.

 

Why Calculate It?

Internal Growth Rate is an important measure for companies because it informs just how much growth can be attained without additional financing. There are two options for additional financier which are debt and equity. Debt comes with the burden of mandatory interest payments which makes costly upfront to use additional debt financing. Equity financing, on the other hand, does not carry any mandatory payments but will lead to a dilution of control for the shareholders. This may have disastrous effects if overdone. Internal Growth Rate can be compared to growth targets and other considerations to weigh on the decision as to how to proceed.

 

Formula

The formula used to calculate Internal Growth Rate can also help us understand some of the rationales behind the importance of the measure. Internal Growth Rate can be calculated using the following formula:

 

Internal Growth Rate = Retention Ratio × Return On Assets

 

The retention ratio in the case of a company is the proportion of profit that is not paid out as a dividend in a given period. The retention ratio is also called plough-back ratio. The formula assumes a constant dividend payout ratio.

 

Internal Growth Rate = (1 – Dividend Payout Ratio) × Return On Assets

 

We already know that Return on Assets simply shows how well the assets have been used to create profit for owners of the company. Net income is derived from the income statement while average total assets are the average of current assets and non-current assets balances at the beginning and end of the year in the Balance Sheet. Interpreting the formula in words we can, therefore, surmise that the Internal Growth Rate is determined by how much of its profits a company retains and how well it utilises its assets to create income. Every dollar of earnings reinvested becomes a dollar of assets. In other words, the increase in business value (the Internal Growth Rate) equals the return on retained earnings.

 

Example

Let us assume you are an investor interested in growth and you have an option between two companies. Accumulator Inc has a policy of paying out 10% or income as a dividend and has a current Return on Assets of 12% while Distributor Inc has a policy of paying out 40% of income and has a similar Return On Assets to that of Accumulator.

 

Accumulator Inc Return on Assets = (1- Dividend Payout Ratio) x Return On Assets

= (1-20%)x 12%

= 80% x 12%

= 9.6%

 

Distributor Inc Return on Assets = (1- Dividend Payout Ratio) x Return On Assets

= (1-40%)x 12%

= 60% x 12%

= 7.2%

 

If we alter Distributors Return on Assets to 15% we get;

Distributor Inc Return on Assets = (1- Dividend Payout Ratio) x Return On Assets

= (1-40%)x 15%

= 60% x 15%

= 9.0%

 

Things that affect Internal Growth Rate

From the above example, we can see that two things will determine Internal Growth Rate; How well a business uses assets to generate income and how much of the income it retains to plough back into operations. Let’s look a little closer.

 

Asset utilisation

The asset utilisation component of Internal Growth Rate is a result of how a company operates. Ultimately how well a business uses assets tells you how much growth it can achieve. This is the most important factor that determines the Internal Growth Rate. But what causes good asset utilisation? The first factor is increasing sales revenue and in stable markets, this is achieved through increased sales volumes. Deploying assets to marketing, customer loyalty, new markets and other methods to increase the market share can all achieve this. To a lesser extent profit is also impacted by the containment of operating expenses and overheads. This can be achieved by using more efficient methods and technologies as well as re-organising business processes. As the denominator in the Return on Assets calculation the size of average assets also plays a part in the asset utilisation. A company with idle assets will see its Return on Assets affected adversely.

 

Retention Ratio

The retention ratio is a matter of company policy. Boards of Directors in conjunction with shareholders decide on dividend payout ratio. Shareholders want some compensation for allowing management to use their capital. Compensation can come in the form of growth of the company value and therefore share value or in the form of dividends paid out to shareholders. Share value appreciation can only be realised when the shares are disposed of through sale. A dividend is however realised immediately as it is paid out. The retention ratio is, therefore, a contentious matter that ultimately depends on shareholder outlook. Are they after immediate returns or are they willing to reinvest profit with management? We have already seen how much this impacts the Internal Growth Rate in our calculation examples.

 

The Internal Growth Rate is an important tool for those evaluating the growth prospects of businesses of all sizes. The formula to calculate it measures how much of profit they retain and how well they use assets, including retained profit, to generate revenue.

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