Internal Growth Rate (IGR) is an integral part of organizations’ accounting systems. Therefore, it is important for you to be familiar with the various aspects of IGR to make smart financial decisions and ensure proper financial calculations.
The purpose of this article is to provide you with information about all of the important aspects of the internal growth rate.
What is Internal Growth Rate?
IGR stands for Internal Growth Rate. It is basically the growth that a firm can maintain without external financing. Retained earnings are the only funding of firms in terms of internal growth rate.
Retained earnings are one of the items that combine the income statement and balance sheet. Retained earnings are the profits that are not distributors to shareholders through a dividend.
Internal growth rates are critical to many businesses, especially small and medium businesses, as it measures the ability to grow profits and sales without external outsourcing.
Internal growth rates can be generated through product diversification and segmentation. Businesses can increase their product line by diversifying the product, or they can introduce a new product line.
There are many other ways to increase the internal growth rate. That will be discussed later but first, let’s go through the basics of IGR.
Formula of Internal Growth Rate
The formula of internal growth rate is:
IGR= internal growth rate
ROA= return on assets
Return on assets basically indicates profitability. It tells that how much a firm is making profits on the assets that are invested. Profitability is directly proportional to ROA. Higher the ROA, higher the profits.
r= retention ratio
It refers to the earning that are kept back in the business for further use. As in IGR, firms don’t rely on outside funding, so retention ratio is the way to reinvest the earning into the business for its growth.
How to Calculate the Internal Growth Rate?
To calculate IGR, you need to have net income and total assets. You can find out the ROA by dividing net income by total assets. You can find out the net income in the income statement. The income statement, also known as the profit/loss statement, is like a movie about profitability during a period. The period can be a month, year, or quarter. Total assets can be found in the balance sheet. A balance sheet is like a picture in point in time of what a company owns and what it owes. The retention ratio can be calculated by dividing retained earnings by net income.
If only the retention ration or payout ratio is given, then you can find the other ratio by simply subtracting.
Payout ratio + retention ratio= 1
The payout ratio is a measure of the percentage of profit a company pays to its shareholders in the form of dividends and is expressed as a percentage of the company’s gross profit.
In many cases, either payout ratio is given, or retention ratio is given. To find any one of them, simply subtract the given ratio by 1.
If there is a case when both the ratios are not given, then you can still find the ratios.
In order to find out the payout ratio, divide the dividends with the net income(NI). For retention ratio, divide the retained earnings(RE) by net income(NI)
Let’s take an example of a company and how it will calculate its IGR. Let’s assume that the income statement says the total sales were 15,000 and cost 12,000. The net income would be 3,000. In the balance sheet of the company, it is mentioned that the total assets are 4,000. Debt is 18,000 and Equity is 22,000.
It is obvious that assets and costs vary with sales, but equity and debt do not vary. The company said that they paid a dividend of 1200, and they wish to maintain the constant payout ratio.
In order to calculate the IGR, you need to first focus on the given data. 1200 of dividend is given, so you can calculate the retained earnings by subtracting net income from dividend which will be 3000-1200= 1800. The next step would be finding out the retention ratio. Divide the retained earnings of 1800 by net income of 3000, and you will get a total of 0.6 or 60%. ROA is simply the division of net income of 3000 by assets of 4000. The ROA would be 0.075 or 75%.
Now you have all the data for your IGR formula = IGR= ROA*r/(1-ROA*r)
Let’s put these values IGR = 0.075*0.6/ (1-0.075*0.6)
IGR= 0.0472 OR 4.721
That’s the maximum that the sales can grow for this company without any external financing.
Assumptions in IGR
If the retained earnings ratio rises or the dividend payment rate falls, the IGR will also tend to rise.
There are additional retained earnings with higher deductions so that more internal funds can be used for growth.
As the rate of return on investment (ROA) increases, so does the IGR. As with the first scenario, it leads to additional retained earnings and then more internal funding for the growth of the company.
In order to have a strong internal growth rate, companies should use all the funds acquired from the retained earnings.
Equity or debt don’t include when dealing with IGR. The reason for that is when dealing with IGR, no outside funding is included, so it doesn’t include equity or debt.
Sales and cost are directly proportional to IGR. When sales or cost increases, IGR also increases.
How to Increase IGR?
If the firms are not financing from outside, then it is hard to improve their overall performance. However, it is not impossible to increase the growth rate. The first thing that firms need to do is to look after their resources efficiently. Resources should be used efficiently and effectively. Make sure that there is no wastage of resources.
Firms should manage their operations and day-to-day activities carefully. There are a lot of tools to manage the operations efficiently, like using the Just in Time inventory management method. Firms can use total quality management(TQM) tools like control charts, histograms, bar charts, Pareto principles, and checklists to improve quality and find solutions.
A firm can improve the performance of its employees by training them. Training employees can result in better productivity, which can be a benefit for the firm’s IGR.
Internet and technology are evolving every day. Firms need to update themselves with the latest SCM tools and other important efficient ways to improve their businesses. SAP and ERP are some of the examples
ERP stands for enterprise resource planning. This software manages all the supply chain, manufacturing, financials, and other processes. Firms can save time and, at the same time, improve productivity by using these types of software.
Improving the lead time can help firms to generate more IGR. Lead time refers to the time between the start and completion of a process or the time between ordering something and receiving it. By reducing the lead time, firms can gain a competitive edge and reduce material inefficiencies.
Introducing a new product line or product diversification helps to increase the IGR. It can help your business to grow. By introducing a new product line, firms can attract new customers and hence more profits.
Internal Growth Rate vs. Sustainable Growth Rate (IGR VS SGR)
Another terminology related to internal growth rate is the sustainable growth rate. Let’s first talk about what is the sustainable growth rate.
It is a growth rate a firm can maintain with a constant debt to equity ratio and no external equity issued. In short, SGR includes external financing but only to a certain limit.
The main difference between internal growth rate and sustainable growth rate is that IGR doesn’t include external financing, while SGR includes external financing.
The formula of sustainable growth rate (SGR) = ROE*r(1-ROE*r)
ROE= return on equity
If the ROE isn’t given in the data, then it can be calculated by dividing net income by shareholder’s equity.
r= retention ratio
the difference in the formula of IGR and SGR is pretty simple. Internal growth rate includes return on assets (ROA), while SGR includes return on equity (ROE).
The bottom line is that internal growth rate (IGR) is one of the most important financial metrics in any organization to evaluate its growth and development. Companies, accountants, and audit firms should pay special attention to ensure IGR is calculated fairly and accurately to get the right results.
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