What Is Retention Ratio?
The retention ratio (also known as the net income retention ratio) is the ratio of a company’s retained income to its net income. The retention ratio measures the percentage of a company’s profits that are reinvested into the company in some way, rather than being paid out to investors 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.
Retention Ratio = Retained Earnings / Net Income
The numerator of this equation calculates the earnings that were retained during the period since all the profits that are not distributed as dividends during the period are kept by the company.
Retained Earnings = Net income- Dividends
Since companies need to retain some portion of their profits in order to continue to operate and grow, investors value this ratio to help predict where companies will be in the future. Apple, for instance, only started paying dividends in the early 2010s. Up until then, the company retained all of its profits every year.
This is true about most tech companies. They rarely give dividends because they want to reinvest and continue to grow at a steady rate. The opposite is true about established companies like GE. GE gives dividends every year to it shareholders.
The size of the retention ratio attracts different types of customers/investors.
Investors who are income-oriented would expect a lower retention ratio, as this suggests high dividend possibilities to the shareholders.
Growth-oriented investors will prefer a high retention ratio implying that the business/firm has profitable internal usage of its earnings. This, in turn, would push up the stock prices.
If the retention ratio is close to 0%, there is a greater possibility of the firm being unable to maintain the existing levels of dividends distributed since it is distributing all returns back to the investors. Thus, sufficient cash is not available to support the capital requirements of the business.
Mr. X’s Company earned Rs.1,00,000 of net income during the year and decided to distribute Rs.20,000 of dividends to its shareholders. Here is how X would calculate its retention ratio.
Retention Ratio= (1,00,000-20,000)/1,00,000= 80%
As one can see, X’s rate of retention is 80 percent. In other words, X keeps 80 percent of his profits in the company. Only 20 percent of his profits are distributed to shareholders. Depending on his industry this could a standard rate or it could be high.