What is Retention Ratio?
How do you calculate the retention ratio?
What are the essential elements you should know!
In this article, I will break down the notion of Retention Ratio so you know all there is to know about it!
Keep reading as I have gathered exactly the information that you need!
Let’s discover what the earnings retention ratio tells us and how to calculate it!
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What Is Retention Ratio
The retention ratio, also known as the plowback ratio, is the ratio allowing you to determine how much earnings a company has “retained” to reinvest in the business.
In other words, the retention ratio allows you to calculate the proportion of earnings kept by the company to fund business operations as opposed to paying the money out as dividends.
For example, if a company has a net income of $1,000,000 and it chooses to keep $900,000 to fund its growth while paying $100,000 in dividends to its shareholders, the company has a retention ratio of 90%.
This means that the company has kept 90% of its net income to fund business growth while it has used 10% to pay its shareholders.
Companies need a constant stream of capital to fund their business operations.
As such, one of the first sources of capital a company will tap into is its net income (or money left over after all its costs, expenses, interest, and taxes have been paid).
The more a company keeps its net income to fund its business, the higher the retention ratio will be.
The more the company pulls out money from its retained earnings to pay dividends to its shareholders, the lower its retention ratio.
A company’s retained earnings are the amount of money a company has leftover in the company after it has paid for all its expenses, taxes, and has paid dividends to its shareholders.
The more a company is able to keep money in its retained earnings, the more the company has access to capital to invest in the business.
When a company is profitable, it can choose to leave some money in its retained earnings for major capital investment, acquisition, or another important business activity.
When a company incurs a loss, it may use money from its retained earnings to cover any financial shortfall.
You can consider the retention ratio to be the opposite of the dividend payout ratio representing the proportion of the money paid out by the corporation to its shareholders.
In our example, the company’s retention ratio is 90% and its payout ratio is 10%.
Investors are interested in knowing how much a company typically retains in the business and how much it generally pays in dividends.
Some investors prefer investing in companies that have a history of paying out a certain proportion of their earnings in dividends.
Other investors looking for growth may want to invest in companies that retain 100% of their earnings to fuel the business operations allowing the company’s stock price to rise over time.
Retention Ratio Definition
According to Investopedia, the retention ratio is defined as follows:
The retention ratio is the proportion of earnings kept back in the business as retained earnings
As you can see from this definition of retention ratio, it is:
- The calculation of a proportion
- Of the company’s net income
- Kept by the company
- To fund business operations
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Why Is The Retention Ratio Important
The retention of profit is a simple but important ratio to understand.
Depending on the company being analyzed, the retention ratio can provide certain insights as to the company’s business operations and management decisions.
If you are an investor, you may be interested to know how much money the company has kept to reinvest in the business.
Compared with similar companies in the same industry or sector, you may be able to see to what extent the company is using its earnings to fund its business.
If the company’s competitors have a retention ratio of 80% but the company you are analyzing is 100%, you can tell that this company is using all its money to fund the business.
This can be either a good thing or a bad thing.
If a company is generating a high amount of revenues, is profitable, and has a 100% retention ratio, you can tell that this company is aggressively looking to expand and grow.
However, if a company’s revenue is low and the company is not generating any profits, it may be wise to keep 100% of its earnings to minimize losses.
In the end, the retention ratio should be considered along with other financial metrics to tell a company’s story.
Another scenario when the retention ratio can tell about the efficiency or effectiveness of a company’s operation is to see at what rate the company is retaining its profits.
If the company is keeping most of its profits and not using its retained earnings properly, it may not be running its business efficiently as it may have raised more debt than needed or have financed itself through the issuance of equity when it may not have been needed.
The retention ratio finance allows you to assess the company’s reinvestment rate and see whether it is managing its earnings properly.
How Does The Retention Ratio Work
When you calculate the earning retention ratio, you are looking to see what percentage of its income a company uses to fund its business needs and operations.
Simply put, a company that keeps all its net income and earnings to continue doing business is a company that will have a 100% retention ratio.
This means that the company has reinvested all its earnings back into the business.
When a company makes a profit through its business operations, it must decide how to allocate its profits in the most efficient and effective way possible.
Growing companies having a strong need for capital will generally want to keep all their earnings to fund their growth.
Companies that are more financially mature or in stable markets may choose to keep a large portion of their earnings and payout some money to their shareholders in the form of dividends.
At the end of the day, the company’s managers or board of directors are responsible for making the best decision for the company.
When a company keeps 100% of its earnings, it can potentially grow faster but may not attract more conservative investors looking for dividends.
A company that pays dividends may find a larger pool of investors looking for a steady stream of cash flows (through dividends) but it may need to raise capital in other ways to fund the business.
Retention Ratio Formula
What is the retention ratio formula?
The retention rate formula is a simple one, as follows:
Retention Ratio = Retained Earnings / Net Income
As you can see from this retention rate formula in finance, you calculate a company’s earnings retention rate by taking its retained earnings and dividing it by its net income.
You can also calculate the retention ratio by taking a company’s net income, subtracting the amount of dividends paid out, and dividing the whole thing by the net income, as follows:
Retention Ratio = (Net Income – Dividends Paid) / Net Income
Both formulas provide you an easy and simple way to calculate retention rate finance.
You can also calculate the retention ratio by using per-share figures, as follows:
Retention Ratio = (Earnings Per Share – Dividends Per Share) / Earnings Per Share
This is another alternative for calculating your profit retention if you only have figures presented to you on a per-share basis.
How To Calculate Retention Ratio
Let’s look at a real example to see how we calculate the retention ratio.
Imagine a company that has a total revenue of $100,000,000.
By looking at its income statement, you can see that the company has to pay various costs and expenses to produce its goods.
After deducting all its expenses, interest, and taxes, the company has a net income of $10,000,000.
In other words, the company hat a net profit of 10% of its total revenues.
The company then takes $1,000,000 to pay dividends to its shareholders.
As a result, it has $9,000,000 leftover to reinvest into its business.
Now, we can calculate its retention ratio.
We must take the company’s net income ($10,000,000) less dividends paid ($1,000,000) divided by its net income ($10,000,000) = 90%.
This company has a relatively high retention ratio as it has decided to keep most of its funds to continue funding the business and has paid out 10% of its profits to its shareholders.
You can also find a retention ratio calculator online if you want to speed up the calculation of your ratio.
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How To Interpret Retention Ratio
What is retention rate in finance and what information does it give us?
Retention in accounting refers to the amounts of earnings, profits, or net income a company has effectively held back (or retained) in the company.
What does it mean to have a high or low retention ratio?
The retention ratio considered in isolation may not provide you a proper financial portrait of the company you are analyzing.
At first glance, you may assume that a high retention ratio is a good thing but that’s not necessarily the case.
You must consider other variables, in addition to the company’s retention ratio, to get a better understanding of a company’s financial health.
For example, a startup or a new company may keep all its earnings to reinvest in the business.
Although the company is using all its profits to fund its business operations, the company is nonetheless a risky company to invest in.
You can also consider a large company having a lower retention rate.
This does not mean that the company is financially at risk.
A company may have generated a lot of profit at some point and wanted to reward its shareholders, as such, it decides to pay a significant portion to its shareholders.
A company may also choose to make an important payment as part of a reorganization or another type of restructuring.
What’s important is that you calculate retention ratio while being mindful of what’s happening with the company, where is the company in its growth lifecycle, how it situates with its peers, and so on.
Earnings Retention Ratio Takeaways
So there you have it folks!
What does the retention ratio mean?
How to calculate retention rate finance?
In this article, we defined the retention ratio to answer the question what is the retention ratio.
We have looked at the retention formula, how to find retention ratio, and all of its relevant aspects.
A company’s retention ratio is the ratio of a company’s “retained income” over its “net income”.
In other words, it’s the measure of how much a company reinvests profits back into the business as opposed to paying them out to shareholders in the form of dividends.
A high retention ratio means that a company is keeping most of its profits in the company for continued business operations.
In essence, the company management believes that by reinvesting the company’s earnings back into the business, they may be able to generate a higher rate of return.
A low retention ratio means that the company keeps less funds in the business and pays out profits to its shareholders.
Growth companies, technology companies, or companies looking to accelerate their growth will tend to keep most of their profits to grow the business.
More mature companies may have a lower retention ratio as the company management believes that a steady payment of profits to its shareholders demonstrates that it has a strong financial position, rewards its shareholders, and is able to attract more equity investors.
You’ll need to look at the retention ratio holistically with other variables to better understand a company’s financial position.
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Now, let’s look at a summary of our findings.
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