Concept Behind Internal Growth Rate Ratio
Internal Growth rate is a measure of the highest growth rate which can be achieved by the company without deploying external sources of finance. It provides insight into how quickly a company can grow using its internal financing. Internal financing would mean a company does not use debt or sell any new shares of the company.
It is the maximum rate of growth which can be achieved without raising new funds either by way of borrowing money or issuing fresh round of shared etc. It is typically calculated by dividing the company's retained profits by total assets and subtracting the rate of earnings retention.
Usually when a company makes profits and these profits are redeployed within to business to undertake any form of expansion, it should result in higher growth rate for the company. Thus internal growth rate hence is useful to understand the maximum growth rate achievable under current business scenario by using profits generated to fuel future expansion plans. It is also explained as the total amount of internal capital available as compared to the current plans of the organisation.
It must be analysed carefully whether this new expansion which is being undertakes is worth investing in and if the company has the capacity to handle it. To improvise on this sustainable growth rate measure is used. Thus internal growth rate ratio is a step towards calculating sustainable growth rate and optimal growth rates.
While calculating the internal growth rate ratio, the retention ratio is based on the target growth rate. The increase in revenues is based on the assumption that asset base will also increase but not at the same rate. This acquisition of assets is funded purely through internal finances like retained earnings and general reserves. The Net profit of the firm is directly proportional to sales.
How Is It Calculated?
Internal Growth rate = ROA x Retention Ratio / 1-(ROA x Retention Ratio)
Here ROA refers to Return on Assets which is calculated as follows:
Return on Asset = Net Profit or income / Total Assets
A Numerical Example:
ABC Company has the following financials
Net Profit = USD 1500
Total assets = USD 10000
Retention Ratio 0.450
Now the Internal Growth Rate Ratio will be calculated as follows
Return on Assets = 1500 / 10000 = 0.15
Retention Ratio = 0.50
Therefore the Internal Growth Rate Ratio for ABC company is = 0.0675
= 6.75%
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