Retention Ratio

What is the Retention Ratio?

The retention ratio formula indicates the percentage of a company’s earnings, which is not paid out as dividends but credited back as retained earnings. This ratio highlights how much of the profit is being retained as profits towards the development of the firm and how much is getting distributed as dividends to the shareholders.

Retention Ratio Formula

Retention Ratio

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For eg:
Source: Retention Ratio (wallstreetmojo.com)

Retention Ratio = Retained Earnings / Net Income

Or

Retention Ratio = 1- Dividend Payout Ratio

The size of the plowback ratio will attract different types of customers/investors.

If the plowback 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.

We see that Amazon and Google have retention of 100% (they retain 100% of profit for reinvestments), whereas Colgate’s ratio is 38.22% in 2016.

Retention-Plowback-Ratio

Examples of Retention Ratio

Let us look into some of the examples for easier understanding:

Assuming Company ‘Z’ reported earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more of $100 and decided to pay $5 in dividends. With the above formula, the Dividend payout ratioDividend Payout RatioThe dividend payout ratio is the ratio between the total amount of dividends paid (preferred and normal dividend) to the company's net income. Formula = Dividends/Net Incomeread more is: $5 / $100 = 20%

This means Company ‘Z’ distributed 20% of its income in dividends and re-invested the rest back in the company, i.e., 80% of the money was plowed back in the company. Thus,

Retention = 1 – ($2 / $10) = 1- 0.20 = 0.80 = 80%

Below is another example of taking a comparison of 2 companies for improved understanding:

Company ‘X’Company ‘Y’
EPS for Previous Year$8.5$10.5
Dividends paid in the previous year per share$4.0$3.0
IndustryUtilitiesTechnology
Net Cash Flow from Investment activitiesPositiveNegative

Retention for Firm ‘X’ = [Dividend / EPS] = $4.0 / $8.5 = 47.05%

Retention or Firm ‘Y’ = $3.0 / $10.5 = 28.57%

The plowback ratio of Company’ X’ suggests that they have been struggling to find any profitable opportunities. Perhaps, the firm does not have many opportunities at the moment and thus will be distributing a reasonable portion of its earnings as dividends. This could also be a temporary tactic to keep a current lot of shareholders satisfied and enhance stock price for the immediate future.

With respect to Company’ Y’, lower retention and negative cash flowsNegative Cash FlowsNegative cash flow refers to the situation when cash spending of the company is more than cash generation in a particular period under consideration. This implies that the total cash inflow from the various activities under consideration is less than the total outflow during the same period.read more highlight the fact that they have been heavily investing in futuristic projects and perhaps may have retained sufficient earnings for future opportunities.

Use of Retention Ratio

Some of the uses of Retention Ratio

  • It is very easy to calculate and suitable for a ball-park comparison amongst firms/sectors.
  • The ratio can work in tandem with the dividend payout ratio to plan the future ideas of the firm.

Calculator

You can use the following this Retention Ratio Calculator

Retained Earnings
Net Income
Retention Ratio Formula
 

Retention Ratio Formula =
Retained Earnings
=
Net Income
0
= 0
0

Calculate Retention Ratio in Excel

Let us now do the same example above in Excel. This is very simple. You need to provide the two inputs of Dividend and EPS. You can easily do the Retention ratio calculation in the template provided.

Plowback

Below is another example of taking a comparison of 2 companies for improved understanding:

Plowback example

You can download this Retention ratio template here – Retention Ratio Excel Template.

Conclusion

It is necessary to understand the investor expectations and capital requirements vary from one industry to another. Thus, a comparison of plowback ratios will make sense when the same industry and/or companies are being made. There is no specific bracket within which the retention ratio should fall into, and various other factors have to be considered before arriving at a conclusion pertaining to the future opportunities of a company. It should be considered just an indicator of possible intentions made by the company.

Retention Ratio Formula Video

Recommended Articles :

This has been a guide to the Retention Ratio. Here we discuss the formula to calculate retentional ratio along with practical examples and its uses and relevance. You may also have a look at these articles below to learn more about Financial Analysis –

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