What Is the Retention Ratio?
Let me explain the retention ratio directly: it's the share of earnings a business holds onto as retained earnings. This is the percentage of net income that stays in the company to support growth, instead of going out as dividends to shareholders. Think of it as the opposite of the payout ratio, which tracks what portion of profits gets handed out. You might also hear it called the plowback ratio.
Understanding the Retention Ratio
When a company turns a profit at the end of a period, it has choices on what to do with that money. It could pay it all out as dividends, keep everything for reinvestment, or split it somehow. The part it keeps is retained earnings, like money set aside for future use. You calculate the retention ratio as a percentage by comparing those retained earnings to total net income. This gives you insight into how much the company is saving to reinvest, which ties into its long-term health. If a company just hoards cash without smart investments or pays it all out, growth could stall, leading to more debt or new stock issues. New companies often skip dividends to fund growth, while established ones balance payouts and reinvestments.
How to Calculate the Retention Ratio
You can figure out the retention ratio in two ways. First, find retained earnings in the shareholders' equity part of the balance sheet and divide it by net income from the income statement. That's Retention Ratio = Retained Earnings / Net Income. The second way skips retained earnings: subtract dividends paid (from the cash flow statement's financing section) from net income, then divide by net income. So, Retention Ratio = (Net Income - Dividends Distributed) / Net Income. Both methods get you to the same place since net income minus dividends equals retained earnings.
Special Considerations
Expect higher retention ratios in fast-growing companies, especially in tech or biotech, where they're plowing money back in for rapid expansion. These firms often skip dividends altogether if they think reinvesting will boost revenues faster than shareholders could on their own. Investors might accept no dividends for strong growth prospects. In mature industries like utilities, ratios are lower because steady dividends are expected. The ratio can fluctuate year to year based on earnings swings or dividend policies—blue chips aim for stable payouts, while cyclical sectors vary more.
Limitations of Using the Retention Ratio
Here's where the retention ratio falls short: it doesn't tell you what the company does with those retained earnings or if the investments are smart. To get the full picture, pair it with other metrics and compare it to industry peers over time to spot trends.
Real World Example
Take Meta, formerly Facebook, from their 2018 10-K filing. Their balance sheet showed retained earnings of $41.981 billion, and net income was $22.112 billion. Divide those: $41.981 billion / $22.112 billion gives about 1.89, or 189%. That's sky-high because they didn't pay dividends and piled up profits for reinvestment—typical for tech giants focused on growth.
Frequently Asked Questions
What is the retention ratio in finance? It's the portion of net income a company keeps instead of paying as dividends, also called the plowback ratio.
More FAQs
- How do you calculate a company’s retention ratio? Divide retained earnings by net income, expressed as a percentage.
- How do you calculate a company’s retained earnings? Subtract dividends distributed from net income.
- What does a company’s retention ratio tell you? It hints at future viability, like if a startup is reinvesting enough for growth, but not how well the money is used.
The Bottom Line
The retention ratio shows you what percentage of net income a company keeps for itself rather than paying out. It helps gauge financial health and growth potential, but use it alongside other tools since it doesn't detail reinvestment quality or success.
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