Internal Growth Rate

What is an 'Internal Growth Rate'

An internal growth rate is the highest level of growth achievable for a business without obtaining outside financing, and a firm's maximum internal growth rate is the level of business operations that can continue to fund and grow the company. Internal growth rate is an important measurement for startup firms and small businesses, because it measures a firm's ability to increase sales and profit without issuing more stock or debt.

BREAKING DOWN 'Internal Growth Rate'

Analysts measure the internal growth rate for a public company by taking the firm's retained earnings and dividing by total assets, or by using return on assets formula (net income / total assets). The two formulas are similar, because retained earnings includes net income from past years, and both ratios measure the profit a business generates by using the assets on the balance sheet. Generating a profit improves the firm’s net cash flow and generates working capital that is used to operate the business.

How Improving Efficiency Generates Growth

If a business can use its existing resources more efficiently, the firm can generate internal growth. Assume, for example, that Acme Sporting Goods manufactures baseball gloves, bats and other equipment, and that management is reviewing current operations. Acme analyzes its production process and makes changes to maximize the use of machinery and equipment and reduce idle time. The company also warehouses finished goods that are sold to sporting goods stores, and management makes changes to reduce the level of inventory carried in the warehouse. These changes increase Acme’s efficiency and reduce the amount of cash tied up in inventory.

Examples of Business Expansion

Another internal growth strategy is to increase the company’s market share for products the firm already sells, and there are several approaches to increase market share. If Acme can improve its marketing results, the company can sell more products without increasing expenses, and many firms build brand recognition to get better marketing outcomes. The sporting goods firm can also develop new products to sell to its existing customer base since current customers already have a relationship with the business and may consider new product offerings. If, for example, Acme makes a popular line of baseball gloves for outfielders, the firm may add a new catcher’s mitt model and sell that product to baseball glove customers.

Factoring in Diversification

Some companies generate internal growth by adding new lines of business that complement the firm’s existing product offerings, and Acme may add a football equipment product line to generate sales when baseball season is over. Acme can market the football product line to the existing baseball customer base since some of those athletes may play both sports.