What is the internal growth rate, how to calculate it, and what to do to boost the internal growth rate? Get the answers you need here.
There are many metrics you can use when estimating your business' growth potential. For businesses that aren't planning on seeking any additional funding, finding the internal growth rate is a good choice for evaluating growth. If you know what your internal growth rate is, you'll be able to better plan for the future of your company. Even better, by learning how to improve your internal growth rate, you'll be able to invest more resources into growth and decrease the time it takes to achieve your company's financial goals.
What is the internal growth rate (IGR)?
The internal growth rate refers to the maximum growth that a company can reasonably achieve without taking on additional sources of funding. Whether it's issuing additional equity, taking a loan out, or getting some other form of funding, there are many ways for a business to raise capital. However, all of those options require a trade-off in one form or another. Because of this, most businesses save those funding options for use as a last resort. Knowing your internal growth rate will let you know how much growth your company can achieve without resorting to other funding options.
Internal growth rate formula
Calculating the internal growth rate for a company starts with understanding the mathematical formula that expresses it. Thankfully, the formula is easy to understand once you know the variables that go into it. The formula itself is simply your return on assets multiplied by your retention ratio. In other words:
ROA x R
Let's now take a closer look at what the results of that formula actually mean.
How to calculate internal growth rate
On the surface, the formula for internal growth rate looks very simple. It only has two variables with a very simple mathematical operation. But what exactly are those two variables? Let's break them down one by one in more depth.
The first variable refers to return on assets (ROA). This number is simply your net income divided by the value of your assets. The thinking here is simple: return on assets tells you how much your business makes each year for assets at a given value. Increasing the value of your assets should, in theory, increase your income proportionally.
The next variable you need is retention ratio (R). This, too, requires a relatively simple calculation to find. Your retention ratio is simply your company's retained earnings divided by net income. Basically, retention ratio refers to the amount of net income available to reinvest in the business for driving growth. Another way of calculating your retention ratio is to subtract one from your dividend payout ratio.
We now have a clearer picture of the thinking behind the internal growth rate calculation. By multiplying the available added assets amount by the amount per each dollar of assets, you have the income generated should you choose to reinvest everything back into your business. This is why IGR is a good metric for determining the maximum amount of growth your brand can achieve without extra funding.
Key differences between a sustainable growth rate vs an internal growth rate
After calculating its internal growth rate, a business may decide that it can't currently afford to grow as fast as it would like without seeking extra funding. Assuming the company wants to retain its capital structure, key decision makers must work with the current equity available in the business. By dividing the net income by equity instead of assets, the return on equity (ROE) can be calculated. To determine the sustainable growth rate then, replace ROA with ROE in the internal growth rate formula and calculate accordingly:
ROE x R
Now, the intuition changes slightly. Whereas internal growth rate is about finding the amount of income brought in when all extra income has been invested in additional assets, sustainable growth rate measures how much growth is achievable when taking on additional debt in line with a growing equity.
How to increase your internal growth rate
Before making the switch to using sustainable growth rate as your primary growth metric, it's a good idea to still take steps that will maximize your internal growth rate. By optimizing asset utilization and minimizing waste, you'll see a greater return on assets and, in turn, a better internal growth rate. Companies should regularly evaluate performance and look for opportunities to improve. Not only will such efforts likely improve profits, but they will also accelerate the company's growth rate.
Optimizing existing production processes
There's often room for improvement in the existing way a business operates. Technology changes fast and allows for greater automation, more streamlining, increased staff productivity, and other operational efficiency increases that will help you squeeze additional revenue out of your existing assets. Regularly checking to ensure your business is operating with the most efficient tools and processes available will help keep your IGR as high as possible.
Re-designing existing product
When products become outdated and fall behind the competition in terms of features and usability, they will no longer bring in as much revenue as they could. By looking at how customers are using your products and how the market has changed expectations since the last product refresh, you can re-design your offerings in a way that will see sales increase. This, in turn, will drive growth and increase your ROA.
Eliminating underperforming product lines
Every product your company puts out uses up assets. Products that are not performing very well are utilizing those assets without contributing their fair share back to your net income. When you drop poorly performing products and put those assets to use on better performing products, your ROA goes up.
Adding new lines of business
This tip won't just increase IGR, but it can also serve as a growth driver in its own right. Almost every product has a complementary product, which is something that customers would also purchase if made available. By looking at your product line and figuring out the most logical additions to your income streams, you can capitalize on that fact. This can be particularly effective for increasing IGR because similar products can often share assets, which gives you an increase in net income and results in greater ROA overall.
How to optimize the internal growth rate with ProfitWell Metrics and Retain
Optimizing your internal growth rate means having complete transparency into your business operations. Without the appropriate data, you'll be unable to determine which areas of your business can be best optimized. ProfitWell Metrics, by Paddle, is a free analytics tool that will provide you with the data you need to optimize business operations and increase your internal growth rate. With tools built especially for SaaS and other subscription businesses, ProfitWell Metrics will empower you to reduce churn, discover how customers are using your products, and more efficiently market your product for reduced customer acquisition costs.
Many customers churn not because they want to, but because of failed payments. For some companies, this can even be a leading cause of churn. Losing that revenue drops your ROA and decreases your yearly growth potential. ProfitWell Retain is a product that combines smart algorithms with our years of expertise to automatically recover those customers for you.
Internal growth rate FAQs
What is the difference between internal and external growth rates?
As we've seen, the internal growth rate is all about organic growth within the company. A business using its profits to reinvest in itself and drive more growth is expanding in an organic way. External growth, on the other hand, relies on extra sources of funding. This type of growth involves capital restructuring, debt financing, and other methods that depend on people external to the business as growth drivers.
Why should I monitor my company's internal growth rate?
The internal growth rate of a business and the two variables that make up its calculation are great indicators of a company's financial health. Even when used as a way to track success, they are highly effective. Measuring your internal growth rate will allow you to forecast how much you can reasonably expect to grow over time and plan your business decisions accordingly.
Is internal growth rate a percentage?
Yes, IGR is a percentage change in your expected net income over a given period of time.
What are the limitations of the internal growth rate?
The internal growth rate is designed to give you the maximum amount of growth income your company can reasonably generate on an annual basis. It does tend to rely on a lot of simplifications to reach its calculations. The most obvious simplification is that it assumes you reinvest every extra penny back into the business. Other assumptions are that you'll maintain a constant income year after year, and that growth will continue to increase linearly with assets. This is why it's important to regularly re-evaluate your IGT to keep up with changing market and business dynamics for a more accurate number.