What is the Retention Ratio?
The Retention Ratio is the portion of net earnings that are retained by a company rather than being paid out as dividends to shareholders.
How to Calculate Retention Ratio (Step-by-Step)
The importance of the retention ratio is related to the fact that companies re-investing their net income into their operations implies that there are growth opportunities worth pursuing in their current pipelines.
For companies profitable at the net income line (i.e. “the bottom line”), there are two options available to the management team in terms of how to use the proceeds:
- Re-Invest into Operations: Maintain possession of those earnings and, on a later date, use them to fund ongoing operations as well as discretionary growth plans
- Compensate Equity Shareholders: Issue payments to preferred and/or common shareholders in the form of dividends
If the former is chosen, the percentage of profits that the company opts to hold onto as opposed to paying out as dividends increases – which is quantified by the retention ratio.
Since the earnings retention of the company is expressed in the form of a percentage, this enables comparisons among peer companies in the same industry.
The inverse of the retention ratio is called the “dividend payout ratio”, which measures the proportion of net income paid out as dividends to shareholders.
Retained Earnings on Balance Sheet
When the earnings of companies are credited to retained earnings instead of being issued out as dividends, the preserved amount flows into the “Retained Earnings” line item on the balance sheet.
To forecast retained earnings, the process consists of taking the prior period balance of retained earnings, adding the net income from the current period, and then subtracting any dividends issued to shareholders.
Factors Affecting the Retention Ratio
Considering the retention ratio – also known as the “plowback ratio” – indicates the amount of retained profits, the fact that a company would decide to keep its profits tends to be a positive sign that management is confident regarding its future business growth opportunities.
However, this interpretation is based on the assumption that management is rational and makes corporate decisions with the “best interests” of its shareholders in mind.
As a general rule, the retention ratio is typically lower for mature, established companies that have accumulated large cash reserves.
Often, such companies are referred to as “cash cows”, as they are characterized by large market share in a mature, single-digit growth industry.
Consequently, these types of companies have minimal reinvestment needs and essentially have developed into a steady turnkey business following years of strong growth to become a market leader.
Boston Consulting Group Growth-Share Matrix (Source: BCG)
Here, the decision-making process is based on whether or not the projects in the current pipeline could be undertaken in the present date – if not, it is often because the risks associated with the projects are not justified by the potential returns.
On the other hand, a high-growth company riding a positive trajectory in terms of market expansion and new customer acquisitions would be comparatively far more likely to retain earnings, as there are more likely to be worthwhile projects worth undertaking.
To expand further, growing companies require additional cash to fund upcoming investments in assets (i.e. capital expenditures) and other strategic operational investments into:
- Sales & Marketing Spend (S&M)
- Advertising Campaigns
- Customer Service and Support
- Business Development Representatives