Retention Ratio
Ratios
Overview
Retention ratio is a financial ratio that measures the amount of earnings retained by a company after dividends have been paid out. The retention ratio is the opposite of the payout ratio, which measures the amount that the company pays to its shareholders as dividends.
The main idea behind the retention rate is that it shows how much of the earnings that the company makes is retained inside the business instead of being distributed to its shareholders. The earnings that the company retains will be used to reinvest in the growth of the business.
Alternative Names: Earning Retention Ratio, Plowback Ratio, Net Income Retention Ratio, Retention Rate
Formula
The retention ratio can be calculated using three different methods:
Method 1 (From Net Income and Dividends):
Retention Ratio = (Net Income − Dividends) ÷ Net Income
Method 2 (From Retained Earnings):
Retention Ratio = Retained Earnings ÷ Net Income
Method 3 (From Payout Ratio):
Retention Ratio = 1 − Payout Ratio
Since the retention ratio is the opposite of the payout ratio, you can calculate it directly using Method 3 if you already know the payout ratio. All values can be found on the company's financial statements (income statement for net income and dividends, statement of retained earnings for retained earnings).
Calculation Example
Let's calculate the retention ratio for a hypothetical company to demonstrate the process:
Example Company - Financial Data:
- Net Income: $1,000,000
- Dividends Paid: $300,000
Step 1: Calculate Retained Earnings
Retained Earnings = Net Income − Dividends
Retained Earnings = $1,000,000 − $300,000
= $700,000
Step 2: Calculate Retention Ratio
Retention Ratio = Retained Earnings ÷ Net Income
Retention Ratio = $700,000 ÷ $1,000,000
= 0.70 or 70%
Interpretation: A retention ratio of 70% means the company retains 70% of its net income for reinvestment in the business, while distributing 30% to shareholders as dividends. This indicates the company is retaining a significant portion of earnings, likely for growth and expansion initiatives.
How to Interpret
When a company retains a large portion of its earnings, it is usually perceived that the business is anticipating high growth and expansion. More established companies usually should have lower retention rates as their growth opportunities are less prevalent.
General Guidelines:
High Retention Ratio (70-100%): Growth-Oriented
Higher retention ratios indicate the company is retaining most of its earnings for reinvestment. This is typically associated with companies anticipating high growth and expansion of the business. As a general principle, if a company is reinvesting its profit and growing at a higher rate, then investors should prefer that the business is retaining and reinvesting as much of its profit as possible.
Moderate Retention Ratio (30-70%): Balanced Approach
A balanced retention ratio indicates the company is splitting its earnings between reinvestment and shareholder returns. This approach is common for companies with moderate growth opportunities that also want to reward shareholders through dividends.
Low Retention Ratio (0-30%): Established Companies
Lower retention ratios are typical for more established companies where growth opportunities are less prevalent. On the other hand, if the company has limited opportunities for growth and the investor has a better way to reinvest the money, then investors should look for lower retention rates with higher dividend payouts.
Important Context: The retention rate can be influenced by other factors as well and is dependent on the industry, macroeconomic conditions, and management style. What's optimal for one company may not be optimal for another. Always consider the company's growth stage, industry dynamics, and investment opportunities when evaluating retention ratios.
Why It Matters
Companies that make profit at the end of a financial period can use the earnings in different ways. They can choose to pay the profits to their shareholders (in the form of dividends) or they can choose to reinvest the profits to grow the business. The retention ratio reveals this strategic allocation decision.
Key Insights:
- Earnings Allocation Strategy: Shows how management is deploying profits between shareholder distributions (dividends) and business reinvestment (growth). This reveals the company's strategic priorities and capital allocation philosophy.
- Growth Expectations Indicator: High retention ratios typically signal that the business is anticipating high growth and expansion opportunities. Management believes it can generate better returns by reinvesting in the business rather than returning cash to shareholders.
- Company Maturity Assessment: Helps identify the company's life cycle stage. Growth-stage companies tend to have high retention ratios, while mature, established companies with limited growth opportunities tend to have lower retention ratios and higher dividend payouts.
- Investment Decision Factor: Helps investors align their expectations with company strategy. Growth-oriented investors may prefer high retention ratios, while income-focused investors may prefer lower retention ratios (higher dividends). If investors have better alternative investments, lower retention may be preferable.
Key Takeaways
- Retention ratio measures the amount of earnings retained by a company after dividends have been paid out
- The opposite of payout ratio—while payout ratio measures dividends paid, retention ratio measures earnings kept
- Shows how much earnings the company retains inside the business vs distributes to shareholders
- Retained earnings are used to reinvest in the growth of the business
- Can be calculated three ways: (Net Income − Dividends) ÷ Net Income, Retained Earnings ÷ Net Income, or 1 − Payout Ratio
- High retention (70-100%) indicates anticipation of high growth and expansion opportunities
- Low retention (0-30%) is typical for established companies where growth opportunities are less prevalent
- If company is growing at a high rate, investors should prefer high retention and reinvestment
- If company has limited growth opportunities and investors have better alternatives, prefer lower retention (higher dividends)
- Influenced by industry, macroeconomic conditions, and management style—context matters significantly
Related Financial Ratios
These related metrics provide additional insights for comprehensive financial analysis:
Dividend Payout Ratio
The opposite of the retention ratio, measuring the percentage of earnings paid out as dividends to shareholders. Calculated as Dividends ÷ Net Income or 1 − Retention Ratio. Together, these two ratios must add up to 100% since earnings are either retained or distributed.