• Finance ,
• 20 Oct

Internal Growth Rate is a benchmark that indicates the maximum amount a firm can grow using it’s existing net income. This means no external financing. This is different than a Sustainable Growth Rate. The major difference is that the Internal Growth rate excludes increases in both external debt and equity financing in this calculation.

Internal Growth Rate

where

Internal Growth Rate

Return on Assets

Retention Rate

Internal Growth Rate

This is the answer we are calculating. If a company does not pay dividends, the Internal Growth rate is the company’s Return on Assets. The Internal Growth Rate will be lower than your Sustainable Growth Rate as adding debt to finance your net income allows a greater ROE value. If your company is not set up as a corporation, then the “owner draws” can be considered the same as dividends and substituted in this equation.

Return on Assets

This variable is actually a ratio. It is the Net Income of a period divided by the “Total Assets”. I put this in quotes on purpose as this definition can change depending on what textbook or website you look at.

In a professional setting, year over year performance is important. Be mindful of the potential inconsistency or misrepresenting how well assets are being used to generate cash. It’s common to average the starting and ending of the period, or use just the assets you had at the beginning of the period. It is important that you do not introduce bias by making things look a certain way to fit a narrative because you are setting expectations with your assumptions.

What I mean by this is if you started out with total assets of 100 for example. Then the next day you make capital purchases and triple it to 300 which it stays at for another 365 days. If you use an average of 200 for the period, you are overstating your Return on Assets. Using 100 would be an even greater misrepresentation in this example.

Retention Rate

Some people refer to this as the Retention Ratio, or more often as the Plowback Ratio. This is the percentage of Retained Earnings the business keeps to help grow the business. The formula for this is explained in more detail in our Retention Rate Article.

Other Considerations

Here is another popular way to compute this formula

We feel that using the formula from an actual text book was better than search engine results. The formula used in this article is from the book “Fundementals of Corporate Finance” by Berk, DeMarzo, and Harford.