Retention Ratio
What Is the Retention Ratio?
The retention ratio is the proportion of earnings kept back in the business as retained earnings. The retention ratio alludes to the percentage of net income that is retained to develop the business, instead of being paid out as dividends. It is something contrary to the payout ratio, which measures the percentage of profit paid out to shareholders as dividends. The retention ratio is likewise called the plowback ratio.
Grasping the Retention Ratio
Companies that make a profit toward the finish of a fiscal period can involve the funds for a number of purposes. The company's management can pay the profit to shareholders as dividends, they can hold it to reinvest in the business for growth, or they can do a blend of both. The portion of the profit that a company decides to hold 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 like a savings account since the cumulative assortment of profit's retained or not paid out to shareholders. Profit can likewise be reinvested back into the company for growth purposes.
The retention ratio assists investors with deciding how much money a company is keeping to reinvest in the company's operation. All on the off chance that a company pays its retained earnings out as dividends or doesn't reinvest back into the business, earnings growth could endure. Likewise, a company that isn't utilizing its retained earnings successfully has an increased likelihood of taking on extra debt or giving new equity shares to finance growth.
Subsequently, the retention ratio assists investors with deciding a company's reinvestment rate. Nonetheless, companies that crowd too much profit probably won't utilize their cash successfully and may be better off had the money been invested in new equipment, technology, or growing product lines.
New companies regularly don't pay dividends since they're actually developing and need the capital to finance growth. Notwithstanding, laid out companies ordinarily pay a portion of their retained earnings out as dividends while likewise reinvesting a portion back into the company.
Step by step instructions to Calculate the Retention Ratio
The formulas for the retention ratio are
or on the other hand the alternative formula is:
There are two methods for ascertaining the retention ratio. The primary formula includes finding retained earnings in the shareholders' equity section of the balance sheet.
- Get the company's net income figure listed at the lower part of its income statement.
- Partition the company's retained earnings by the net income figure.
The alternative formula doesn't utilize retained earnings yet rather deducts dividends distributed from net income and partitions the outcome by net income.
Special Considerations
The retention ratio is regularly higher for growth companies that are encountering fast expansions in incomes and profits. A growth company would like to plow earnings back into its business on the off chance that it accepts that it can reward its shareholders by expanding incomes and profits at a quicker pace than shareholders could accomplish by investing their dividend receipts.
Investors might forego dividends on the off chance that a company has high growth possibilities, which is commonly the case with companies in sectors like technology and biotechnology.
The retention rate for technology companies in a moderately beginning phase of development is generally 100%, as they only occasionally pay dividends. Be that as it may, in mature sectors like utilities and telecommunications, where investors expect a reasonable dividend, the retention ratio is regularly very low due to the high dividend payout ratio.
The retention ratio might change over time, contingent upon the company's earnings volatility and dividend payment policy. Numerous blue chip companies have a policy of paying consistently expanding or, in any event, stable dividends. Companies in defensive sectors, for example, drugs 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 lot of retained earnings will likely have a high retention ratio, however that doesn't be guaranteed to mean the company is investing those funds back into the company.
Likewise, a retention ratio doesn't work out how the funds are invested or on the other hand on the off chance that any investment back into the company was done really. It's best to use the retention ratio alongside other financial metrics to decide how well a company is conveying its retained earnings into investments.
Similarly as with any financial ratio, it's additionally important to compare the outcomes with companies in similar industry as well as monitor the ratio north of several quarters to decide whether there's any trend.
Real World Example
Below is a copy of the balance sheet for Meta (META), formerly Facebook, as reported in the company's annual 10-K, which was recorded on Jan. 31, 2019.
- In the shareholders' equity section, the company's retained earnings added up to $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 a similar period.
- Work out its retention ratio by the following: $41.981 billion/$22.112 billion, which equals 1.89 or 189%.
The explanation the retention ratio is so high is that the tech company has accumulated profit and didn't pay dividends. Accordingly, the company had a lot of retained earnings to invest in the company's future. A high retention ratio is exceptionally common for technology companies.
Highlights
- After dividends have been paid out, the amount of profit left over is known as retained earnings.
- The retention ratio assists investors with deciding how much money a company is keeping to reinvest in the company's operations.
- The retention ratio is the portion of earnings kept back in a firm to develop the business rather than being paid out as dividends to shareholders.
- The payout ratio is something contrary to the retention ratio which measures the percentage of profits paid out as dividends to shareholders.
- Developing companies commonly have high retention ratios as they are investing earnings back into the company to quickly develop.
