The retention ratio is one of the key financial ratios used to assess a company’s reinvestment rate. Also called the plowback ratio, it is of great significance to investors, analysts and other stakeholders. In this article, we examine the meaning of the retention ratio, its significance, the retention ratio formula and other aspects related to this indicator.
What is the retention ratio?
The retention ratio is a mathematical indicator that measures how much of a company’s net income is retained by the entity instead of being distributed as dividends. Typically, when a company earns profits during a financial year, it may choose to reinvest all of the net income in its business or it may distribute a portion of the profits as dividends.
The retention ratio evaluates the percentage of the net income that the company retains and reinvests in its business. So, it is the inverse of the dividend payout ratio, which computes the percentage of a company’s net income that is distributed as dividends. Together, the retention ratio and the dividend payout ratio should add up to 100% of the net income.
Formula of Retention ratio
Since this metric compares a company’s retained profits with its net income, the retention ratio formula is as follows:
Retention Ratio = (Net Income — Dividends Paid) ÷ Net Income
Here, the difference between the net income and the dividends paid gives you the retained profits. You can also calculate the retention ratio if you know the dividend payout ratio. This alternative retention ratio formula using the dividend payout ratio is as follows:
Retention Ratio = 100% — Dividend Payout Ratio (in %)
This is because the sum of the dividends paid and the retained profits should give you the net income of the company.
How to calculate Retention ratio?
Now that you know the retention ratio formula, it becomes easier to understand how to calculate this financial indicator. Here is how you can find this ratio.
Step 1: Find the net income
The first step is to identify the net income of a company during the financial year for which you want to compute the retention ratio.
Step 2: Find the dividends paid
If the company paid any dividends during this financial year, ensure that you find the total amount of dividends paid.
Step 3: Calculate the retained profits
Subtract the dividends paid from the net income of the company. This will give you the amount of the net income that the company retains.
Step 4: Retention ratio calculation
The retention ratio is then easy to calculate. Simply divide the retained profits by the net income and express the result as a percentage.
Example of the retention ratio
Let us discuss an example to obtain more clarity on the retention ratio calculation process. Consider the following scenario. A company reports a net income of Rs. 20 lakhs in FY23. During the same year, say the company paid Rs. 2 lakhs as dividends to its shareholders. Using the retention ratio formula, here is how you can calculate the indicator.
Retention ratio:
= (Net Income — Dividends Paid) ÷ Net Income
= (Rs. 20 lakhs — Rs. 2 lakhs) ÷ Rs. 20 lakhs
= Rs. 18 lakhs ÷ Rs. 20 lakhs
= 0.9 or 90%
This means that the company retained 90% of its net income and paid out 10% as dividends to its shareholders.
Related articles to read
- What is current ratio?
- What is the cash ratio?
- What is Treynor Ratio?
- What is the quick ratio?
- What is expense ratio?
- What are mutual fund ratios?
Why is the retention ratio significant?
The retention ratio is a significant measure in financial analysis. It tells you how much of a company’s earnings are distributed and how much is retained to further the company’s growth. At the end of each financial year, a company may earn profits or incur losses. If the company is profitable, the management may decide to distribute a portion of the profits to the company’s shareholders immediately as dividends.
The amount remaining after these dividends are paid out is reinvested in the company and used to help the entity grow. If a company distributes most or all of its earnings as dividends, it is left with little to no funds to drive future growth. This may be a red flag for long-term investors who bank on the company’s progress over the years.
To evaluate whether or not a company is utilising its profits to fund its growth, investors and other stakeholders use the retention ratio. It essentially gives you a snapshot of how effectively a company is using its net income or profits.
Interpreting the retention ratio
Knowing the meaning of the retention ratio and how to calculate it is not enough. You need to know how to interpret the results.
As a general rule of thumb, the higher the ratio, the better it is for investors with a long-term outlook. This is because a high retention ratio indicates that the company is retaining most of its earnings to finance future growth and development. Typically, companies in the initial stages of their growth tend to retain a higher percentage of their net income because they need the additional funds to support accelerated growth. If a growing company pays high dividends, it may be a potential red flag and signal that the company does not reinvest sufficient profits back into the business.
However, larger and more established companies in the later stages of their growth may pay out higher dividends more frequently. In such cases, a low retention ratio may not be a significant cause for concern because the company may be at a more mature stage of its growth. So, it can afford to pay out higher dividends without compromising its financial stability and growth prospects.
This essentially means that you need to calculate the retention ratio and interpret it based on the growth stage of a company rather than assess it as an absolute value.
Limitations of the retention ratio
Although the retention ratio can be useful in many ways, it has some limitations, as outlined below:
- No insight into the usage of funds: The retention ratio does not tell you how a company uses its retained earnings. So, a high ratio may not necessarily be a good sign if the company is not using the retained profits for further growth.
- Overlooking profitability: The ratio also offers no information about the profitability of a company. So, a company with a high retention ratio but low profitability may not have sufficient funds to fuel growth.
- Industry-related differences: The retention ratio also depends greatly on the industry in which a company operates. Some, like tech companies, may reinvest more of their profits back into the business, while others, like utility companies, may pay dividends more frequently.
- Short-term focus: The retention ratio is typically calculated only for one year. So, it ignores the potential long-term growth strategy of a company and narrows the focus down to the short term alone.
Retention ratio vs Dividend payout ratio: Key differences
The dividend payout ratio and the retention rate are two sides of a coin. They complement one another but also differ in many ways. Check out the key differences between these two ratios in the table below:
| Particulars | Retention Ratio | Dividend Payout Ratio |
| Meaning | This is the percentage of net income retained by a company | This is the percentage of net income paid out as dividends |
| Formula | Retained profits ÷ Net income | Dividends paid ÷ Net income |
| Focus | Internal growth and future investments | Shareholder returns in the form of dividends |
| Interpretation | A high value means the company retains more earnings for reinvestment, while a low value means the company distributes more earnings as dividends | A high value means the company distributes more earnings as dividends, while a low value means the company retains more earnings for reinvestment |
| Preference | Investors who prefer growth-oriented companies may check the retention ratio | Investors who want to secure a source of additional income via dividends may consider this ratio |
| Industry-based variation | Varies by industry and is generally high in capital-intensive industries | Varies by industry and can be high in mature industries |
| Implications | Suggests growth potential and expansion | Suggests the focus is on returning value to shareholders |
Factors that affect the retention ratio
The retention ratio is influenced by a wide range of factors that may be specific to the company or generic to the industry in which it operates. These factors include:
1. Industry dynamics
The industry in which a company operates may influence how much of its earnings are retained or distributed as profits. Some industries, like technology, may have more companies that reinvest their profits in the business. Others, like the utilities sector, may have more companies that pay frequent dividends.
2. Growth opportunities
The growth prospects available to a company also affect its decision to retain its earnings or distribute them as dividends. A company that has more growth opportunities may likely choose to retain most or all of its earnings. Meanwhile, a company that has already leveraged its growth prospects may offer more dividends instead.
3. Dividend payment policies
Some companies may have specific dividend policies they may need to adhere to. If the policies require payment of high or frequent dividends, such companies may have a low retention ratio. Conversely, companies that are required by policy to pay a limited dividend may have more funds left to reinvest in their business.
4. Volatility in earnings
For companies in industries that are less stable, the earnings may vary greatly year on year. This, in turn, can affect the retention ratio of such entities. During periods of high earnings, a company may choose to retain a larger portion of the profits for future growth. Conversely, when the profits are low, a portion may be distributed as dividends (or vice versa).
5. Strategic policies
The strategic growth policies of a company also determine how much of its profits can be retained or distributed. Companies that aim to grow rapidly by buying out other firms or expanding across the country may need to retain a higher portion of their profits. This leads to a higher retention ratio.
Additional things to know about the retention ratio
The retention ratio depends on whether or not a company needs to focus on its growth. At the outset, it may seem that investors would prefer companies that pay dividends instead of retaining their earnings. In other words, companies with a low retention ratio may seem favourable for investors.
However, dividends are not the only consideration that investors look at before choosing a company. In many cases, a low retention ratio is not a red flag if it means that the company is redirecting its earnings to bring about future growth. This can be beneficial for investors as it improves the chances of capital appreciation over the long term. Furthermore, the retention ratio may fluctuate significantly from one year to the next, depending on changes in its earnings, dividend policies and growth opportunities.
Key takeaways
- The retention ratio tells you how much of its earnings are retained or reinvested by a company back into its business.
- A high retention ratio indicates that the company reinvests most of its earnings, while a low ratio means that the company utilises most of its net income to distribute dividends instead.
- The retention ratio depends on many factors including a company’s growth prospects, dividend policies and strategic growth plans.
Conclusion
If you want to capitalise on a company’s growth prospects, you need to identify stocks of companies with high retention ratios and add them to your portfolio. However, if this seems like a challenge because of the frequent analyses and decisions involved, investing in mutual funds may be an easier alternative.
Growth mutual fund schemes, in particular, focus on stocks that have a high growth potential. These schemes are managed by fund managers who use their experience and skill to identify the stocks that may grow significantly over the long term. You simply need to compare mutual funds in this category and choose the ones with the best cost-benefit ratio.
With over 1,000 fund options, the Bajaj Finserv Mutual Fund Platform can help you start investing in growth mutual funds today. You can also use the mutual fund calculator on this platform to make strategic investment choices.
