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Retention Ratio (What It Means And How It Works: Full Overview)

What is Retention Ratio?

How do you calculate the retention ratio?

What are the essential elements you should know!

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!

Are you ready?

Let’s get started!

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.

Retained Earnings

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.

Payout Ratio

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
Author

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 

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
Author

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
Author

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
Author

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.

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.

My Investing, Business, and Law Blog

By the way, on this blog, I focus on topics related to starting a business, business contracts, and investing, making money geared to beginners, entrepreneurs, business owners, or anyone eager to learn. 

Just so you know who I am and where I come from, a little about me…

I have a university degree in finance and law. 

I have worked in an international financial institution dealing with the stock market, stock, bonds, corporate financing, and securities.

I practiced law in private practice where I advised and consulted entrepreneurs and business owners on many aspects of their business, such as how to start new business ventures, how to scale their business, how to navigate commercial contracts, and how to set themselves up for success. 

I also acted as an in-house counsel and eventually as the General Counsel in a rapidly growing technology company going through hypergrowth, dealing with international Fortune 500 clients, and operating internationally. 

Let me tell you, in my career, I’ve learned a lot about business, investing, investment decisions, business decisions, and law. 

I started this blog out of my passion to share my knowledge with you in the areas of finance, investing, business, and law, topics that I truly love and have spent decades perfecting.

You may find useful nuggets of wisdom to help you in your entrepreneurship journey and as an investor.

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Now, let’s look at a summary of our findings.

Retention Ratio Definition

  • The “retention ratio” is the proportion of net income a company keeps to fund its business operations
  • When a company keeps more cash to fund the business operations, the company considers that it can achieve a higher rate of return by reinvesting the money into the business than paying dividends out to shareholders 
  • A company with a lower retention ratio is favoring the payment of profits to shareholders to reward them for being shareholders or attract new investors looking for income stocks 
  • The dividend payout ratio is the opposite of the company’s retention rate as it’s the measure of how much a company is paying out money to its shareholders from its retained earnings 
  • You must calculate the retention ratio and analyze it along with other financial metrics and information about the company to gain valuable insight into the company’s financial health 
Board of directors 
Cash flow statement 
Cost of capital 
Current ratio
Debt-to-equity ratio
Dividend payout ratio
Dividends per share
Earnings per share
Financial leverage 
Forward PE ratio
Gross profit margin
Interest coverage ratio 
Negative retention 
Net profit margin 
Operating expense ratio
Plowback ratio 
Profit analysis 
Rate of return 
Retained earnings 
Retention growth model 
Shareholder’s equity 
Statement of retained earnings 
Tax retention rate 
Trailing PE
Win/loss ratio
Author
Angel investors 
Bank loan 
Business loan
Corporate bonds
Corporate debentures
Debt indenture 
Debt securities
Dividend stock
EBIT 
Equity multiplier
Equity securities 
Interest expenses 
Net working capital 
Reddit value investing 
Times interest earned ratio 
Value investing vs growth investing 
Venture capitalist financing
Warrants
Author
Editorial Staff
Hello Nation! I'm a lawyer by trade and an entrepreneur by spirit. I'm passionate about law, business, marketing and technology. On this blog, I share my experiences, provide you with golden nuggets of information about business, law, marketing and technology. Enjoy!

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