Retention Ratio Explained: How to Calculate Retention Ratios

The retention ratio is a financial ratio that helps investors see how much a company can invest in growth over a period of time. When established companies earn a profit, they typically pay out some of the company's earnings as dividends to shareholders. The leftover earnings are known as retained earnings. The earnings retention ratio, also known as the plowback ratio, is the percentage of net income a company keeps as retained earnings after dividend payments are doled out. The retention ratio is the opposite of the payout ratio (also known as the dividend payout ratio).

A company's retention ratio plays a significant role in valuation, as it helps investors determine how much of the profit a company can be reinvesting in future growth. There are many reasons a company may have a high or low retention ratio. For example, a values-based company may have a low retention rate because it gives a large portion of its earnings to charity. On the other hand, a high-growth company may be rapidly reinvesting funds into new products or services while deferring payouts to shareholders. All of these factors are worth considering when performing a retention ratio analysis.

There are two ways to calculate the retention ratio.

1. 1. Retention Ratio = Retained Earnings / Net Income: This retention ratio formula requires locating the company's retained earnings. Locate this metric in the shareholder's equity portion of the company’s balance sheet. Next, check the company's income statement to find its net income. Divide the retained earnings by the net income.
2. 2. Retention Ratio = (Net Income – Dividends Distributed) / Net Income. If you cannot find a company’s retained earnings on its financial statements, this formula will help you arrive at the same result. Simply subtract the distributed dividends from the net income, and then divide this figure by the net income.

There are several limitations to the retention ratio worth considering.

1. 1. The retention ratio does not calculate how funds are used. Though the retention ratio does help investors determine a company's reinvestment rate, it does not show how it is using the funds. You’ll need to look at other financial metrics to determine how a company is reinvesting its retained earnings and to what extent they have been successful.
2. 2. The retention ratio is not always an indicator of growth. A mature company with a significant amount of retained earnings will have a high retention ratio. It would be easy to assume that this must mean they're a high-growth company. However, the company may not be reinvesting its retained earnings into expanding business operations.
3. 3. The retention ratio is only useful in comparing companies of similar scale. Emerging companies often do not have the same cash flow as more mature, established companies and may be more likely to have a low retention ratio by comparison. It’s only useful to compare retention ratios among companies within the same industry and at a similar stage of growth.
4. 4. A higher retention ratio is not always a sign of financial health. Growth investors will look at a company's retention ratio to determine whether the company can reinvest funds for the sake of growth. These investors are operating on the principle that a high retention rate indicates a potential rise in stock price. However, this is not always the case as sometimes company management retains more of its earnings in anticipation of impending financial hardships.

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