Retention RatioDefined along with Formulas & How to Calculate

Written By:
Lisa Borga

What is the Retention Ratio

The retention ratio is the portion of a company’s earnings that are kept by a company as retained earnings rather than being paid out to shareholders as dividends.

The retention ratio, also known as the plowback ratio, is the percentage of net income that a company retains for growth rather than paying it to shareholders.

This is a key metric for investors because it indicates that a company may be undertaking a growth opportunity.

This metric is also the inverse of the payout ratio that measures what percentage of profit a company pays out to its shareholders in dividends.

Understanding the Retention Ratio

If a company has a profitable net income, then at the end of a fiscal period, a company has two options for how it can proceed.

Management could choose to issue payments to its shareholders in the form of dividends.

Alternatively, they could choose to reinvest into their operations to fund growth, or a company could choose to perform a mixture of both.

A company’s retained earnings are the amount of money that is left over after any dividend payments are made.

These retained earnings are the total profits a company has accumulated since its inception that have not been paid out as dividends to shareholders.

The retention ratio is valuable for investors because it shows how much of its profits a company is retaining for reinvestment in the company.

If a company chooses to pay all of its retained earnings to its shareholders, this would often result in a low rate of growth.

This may also lead to a greater amount of debt financing, and potentially the issue of new shares of equity to receive the financing it needs.

By using the retention ratio, investors can find a company’s rate of reinvestment and, as a result, where a company stands.

However, though a high retention ratio is often a promising indication that a company has growth opportunities in the works, this is not always the case.

A company with a high retention rate could simply be using cash ineffectively and may benefit from using the money for investing in new equipment or products instead.

This is why most companies will not issue dividends during their new and growing stage in order to instead spend the money reinvesting in its operations and growth.

Highly established companies, on the other hand, will generally pay some of their profits to their investors as dividends and retain a portion to reinvest into the company.

How to Calculate the Retention Ratio

There are a couple of different formulas for computing the retention ratio.

One formula is:

Retention Ratio = Retained Earnings / Net Income

This formula requires you to find the retained earnings on the balance sheet.

You can find this in the stockholders’ equity section.

You’ll also need to find the net income, which is at the bottom of the income statement.

The second formula is:

Retention Ratio = Net Income – Dividends Distributed

This second formula uses the net income and the dividends distributed.

The dividends distributed can be found on the statement of cash flow.

Special Considerations

The retention ratio is generally higher if a company is a growth company that has had increasing profits and revenues.

These companies tend to reinvest their earnings in the business if they believe it would be beneficial to stockholders by increasing profits and revenues better than they would get if they invested the dividends they received now.

Sometimes investors are fine with skipping dividends if they believe the company has a good chance of high growth, and this is common in technology or biotechnology companies.

Technology companies that are just starting out often have high retention rates because they rarely pay dividends.

However, businesses in mature sectors tend to pay dividends regularly because their stockholders expect it; thus, they tend to have a low retention ratio.

Limitations When Using the Retention Ratio

One limitation to consider when using the retention ratio is that company’s with large retained earnings will probably have a retention ratio that is high.

Yet, the company may not be investing these earnings in the company.

Additionally, the retention ratio doesn’t indicate if the retained earnings that were invested were invested wisely.

Because of these problems, it is best to use other financial assessments in addition to the retention ratio to see if a company effectively invested any retained earnings it put back into the business.

Furthermore, it is also best to compare the company you are looking at with other companies in the same industry when using financial ratios and to look at the ratio over a period of time in case there has been a trend.

Example of Retention Ratio

A copy of Albertsons Companies, Inc. and Subsidiaries’ consolidated balance sheet is presented below.

The balance sheet is for the period ending on February 27, 2021.

Albertsons has retained earnings of $1,263 million, as shown in the stockholders’ equity section of the balance sheet.

They had a net income of $850.2 million, which was obtained from their income statement.

Albertsons has a retention ratio of 1.49 or 149%, which was obtained by dividing the retained earnings of $1,263 million by the net income of $850.2.

Albertsons Companies, Inc. and Subsidiaries

Consolidated Balance Sheets

(in millions, except share data)

Key Takeaways

• The retention ratio measures the percentage of earnings that a company retains for growth opportunities rather than paying to shareholders.
• Once any dividends are paid, any remaining profit is referred to as retained earnings.
• The retention ratio is a key metric for investors because it shows the amount of money that a company is retaining for growth.
• A growing company will generally have a high retention ratio because they are reinvesting their profit to fuel their growth.
• The retention ratio is the inverse of the payout ratio, with the latter measuring the percentage of profit a company pays out to its shareholders.