The DuPont Equation, ROE, ROA, and Growth

However, your financial risk increases when you chase too little or too much growth. Both the internal growth rate and sustainable growth are good methodical
ways to estimate growth. The internal growth rate is the more conservative
measure of the two as it does not assume any additional debt is issued. The
sustainable growth rate is probably the most realistic growth measure of the
two, in my opinion, as any responsible management would be appropriately
leveraging assets.

• If a company can make its operations efficient, thereby increasing its profits and reinvesting those profits to grow, it can achieve an excellent internal growth rate of Return.
• Yes, it is a percentage showing the rate at which the business can grow without external financing.
• It shows a grid of potential growth rates at varying ROEs and earning retention rates.
• Losing that revenue drops your ROA and decreases your yearly growth potential.

An internal growth rate is a business metric used to understand how a company’s internal revenue is growing. An internal growth rate is a measure of the change in internal revenue over time with respect to the assets of a company. It is the maximum level of business operations that can continue to grow and fund the firm. This level of growth can be reached by adding more product lines or expanding the existing ones.

Other related Finance Calculators

Expansion may strain managers’ capacity to monitor and handle the company’s operations. Therefore, a more commonly used measure is the sustainable growth rate. There is another parameter that is related to the internal growth rate, internal growth rate formula and that is a sustainable growth rate. A sustainable growth rate assumes that a company can achieve its growth rate while keeping its current capital structure intact, which refers to the existing combination of debt and equity.

It’s essentially the growth that a firm can supply by reinvesting its earnings. This can be described as (retained earnings)/(total assets), or conceptually as the total amount of internal capital available compared to the current size of the organization. An internal growth rate for a public company is calculated by first using the return on assets formula (net income divided by average total assets).

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Unlike Return on Equity, Return on Assets also considers the business’s liability for knowing the company’s efficiency. Through IGR, investors can determine whether or not the company’s current potential fulfills its expectations. Yes, IGR is a percentage change in your expected net income over a given period of time. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader.

The second formula divides the retained earnings by the company’s net income, which can be obtained from the bottom of the income statement. Before calculating, one must determine the return on assets and the retention ratio. It is also known as the “operational growth rate” because it does not consider additional money from outside the business. It is an important appraisal for startups and small businesses as it measures the business’s ability to increase sales and profit without issuing new debt or equity.

Growth Insights in the Sustainable Growth Rate Formula

Companies may use the internal growth rate as a way to help determine how they may more effectively use their existing resources to efficiently achieve growth. The ROA-times-leverage formula above says you can magnify your return on equity (ROE) simply by increasing your leverage. However, increasing leverage (i.e., increasing debt) also increases your risk of bankruptcy in a cash crisis. It shows a grid of potential growth rates at varying ROEs and earning retention rates. It shows how much the company can grow without needing additional financing and helps identify the company’s current stage in the business life cycle. Creditors or lenders use this metric to assess the likelihood of the company defaulting on loan payments.

One way to increase your growth rate is to invest more cash into your company. The second half of the formula paraphrase tells us that the amount of cash you keep in the company greatly impacts your growth rate. It’s about your profit margin but it also is about the cash conversion cycle and all the related turnover ratios. Their ROE is calculated as $4 million divided by $16 million, which is 25%. Their earnings retention rate is 75%, which we calculated in the previous slide. Many of our students mix up the difference between sustainable growth rate and internal growth rate.

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The final input left is the return on assets (ROA), which we calculate by dividing the net income by average total assets. The retention ratio can also be calculated by one minus the dividend payout ratio. For a manufacturing company, this could potentially involve studying its current use of labor and machinery hours to minimize idle time and achieve maximum productivity.

We find the sustainable growth rate by dividing net income by shareholder equity (or finding return on equity) and subtracting the rate of earnings retention. In fact, in order to achieve a higher growth rate, the company would have to invest more equity capital, increase its financial leverage, or increase the target profit margin. The true benefit of a high return on equity arises when retained earnings are reinvested into the company’s operations. Such reinvestment should, in turn, lead to a high rate of growth for the company. The internal growth rate is a formula for calculating maximum growth rate that a firm can achieve without resorting to external financing.

What Can Be Learned From the Internal Growth Rate?

The formula I just gave to you is good if you want to grab numbers from the balance sheet and income statement to calculate your sustainable growth rate. The fear of formulas may have some of you breaking out now in a cold sweat. I have a free sustainable growth rate calculator you can download that does the math for you.