What Is the Retention Ratio?
The retention ratio is the proportion of earnings kept back in the business as retained earnings. The retention ratio refers to the percentage of net income that is retained to grow the business, rather than being paid out as dividends. It is the opposite of the payout ratio, which measures the percentage of profit paid out to shareholders as dividends. The retention ratio is also called the plowback ratio.
- The retention ratio is the portion of earnings kept back in a firm to grow the business as opposed to being paid out as dividends to shareholders.
- The payout ratio is the opposite of the retention ratio which measures the percentage of profits paid out as dividends to shareholders.
- After dividends have been paid out, the amount of profit left over is known as retained earnings.
- The retention ratio helps investors determine how much money a company is keeping to reinvest in the company's operations.
- Growing companies typically have high retention ratios as they are investing earnings back into the company to grow rapidly.
Dividend Ratios: Payout And Retention
Understanding the Retention Ratio
Companies that make a profit at the end of a fiscal period can use the funds for a number of purposes. The company's management can pay the profit to shareholders as dividends, they can retain it to reinvest in the business for growth, or they can do some combination of both. The portion of the profit that a company chooses to retain or save for later use is called retained earnings.
Retained earnings is the amount of net income left over for the business after it has paid out dividends to its shareholders. A business generates earnings that can be positive (profits) or negative (losses).
Retained earnings are similar to a savings account because it's the cumulative collection of profit that's retained or not paid out to shareholders. Profit can also be reinvested back into the company for growth purposes.
The retention ratio helps investors determine how much money a company is keeping to reinvest in the company's operation. If a company pays all of its retained earnings out as dividends or does not reinvest back into the business, earnings growth might suffer. Also, a company that is not using its retained earnings effectively has an increased likelihood of taking on additional debt or issuing new equity shares to finance growth.
As a result, the retention ratio helps investors determine a company's reinvestment rate. However, companies that hoard too much profit might not be using their cash effectively and might be better off had the money been invested in new equipment, technology, or expanding product lines.
New companies typically don't pay dividends since they're still growing and need the capital to finance growth. However, established companies usually pay a portion of their retained earnings out as dividends while also reinvesting a portion back into the company.
How to Calculate the Retention Ratio
The formulas for the retention ratio are
Retention Ratio=Net IncomeRetained Earnings
or the alternative formula is:
Retention Ratio=Net IncomeNet Income− Dividends Distributed
There are two ways to calculate the retention ratio. The first formula involves locating retained earnings in the shareholders' equity section of the balance sheet.
- Obtain the company's net income figure listed at the bottom of its income statement.
- Divide the company's retained earnings by the net income figure.
The alternative formula does not use retained earnings but instead subtracts dividends distributed from net income and divides the result by net income.
The retention ratio is typically higher for growth companies that are experiencing rapid increases in revenues and profits. A growth company would prefer to plow earnings back into its business if it believes that it can reward its shareholders by increasing revenues and profits at a faster pace than shareholders could achieve by investing their dividend receipts.
Investors may be willing to forego dividends if a company has high growth prospects, which is typically the case with companies in sectors such as technology and biotechnology.
The retention rate for technology companies in a relatively early stage of development is generally 100%, as they seldom pay dividends. But in mature sectors such as utilities and telecommunications, where investors expect a reasonable dividend, the retention ratio is typically quite low because of the high dividend payout ratio.
The retention ratio may change from one year to the next, depending on the company’s earnings volatility and dividend payment policy. Many blue chip companies have a policy of paying steadily increasing or, at least, stable dividends. Companies in defensive sectors such as pharmaceuticals and consumer staples are likely to have more stable payout and retention ratios than energy and commodity companies, whose earnings are more cyclical.
Limitations of Using the Retention Ratio
A limitation of the retention ratio is that companies that have a significant amount of retained earnings will likely have a high retention ratio, but that doesn't necessarily mean the company is investing those funds back into the company.
Also, a retention ratio doesn't calculate how the funds are invested or if any investment back into the company was done effectively. It's best to utilize the retention ratio along with other financial metrics to determine how well a company is deploying its retained earnings into investments.
As with any financial ratio, it's also important to compare the results with companies in the same industry as well as monitor the ratio over several quarters to determine if there's any trend.
Real World Example
- In the shareholders' equity section, the company's retained earnings totaled $41.981 billion for the period (highlighted in green).
- From the company's income statement (not shown) it posted a profit or net income of $22.112 billion for the same period.
- Calculate its retention ratio by the following: $41.981 billion / $22.112 billion, which equals 1.89 or 189%.
The reason the retention ratio is so high is that the tech company has accumulated profit and didn't pay dividends. As a result, the company had plenty of retained earnings to invest in the company's future. A high retention ratio is very common for technology companies.