Retention ratio

Alternative names: Earning Retention Ratio Plowback Ratio net income retention ratio retention rate

What is retention ratio

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 payout ratio that 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 form the earnings that the company makes is retaining inside the business instead of distributing to its shareholders. The earnings that the company retain will be used to reinvest in the growth of the business.

How to calculate retention rate

Retention rate formula can be calculated as follows:

Retention Ratio = (Net Income - Dividends) / Net Income

Or alternative retention rate formula:

Retention Ratio = Retained Earnings / Net Income

Since retention rate is opposite of payout rate, another way to calculate it is:

Retention Rate = 1 - Payout Rate

Why is retention rate important

Companies that make profit at the end of financial period can use the earnings in different ways. They can choose to pay the profits to its shareholders (in a form of a dividend) or they can choose to reinvest the profits to grow the business. When a company retains a large portion of its earnings usually it is perceived that the business is having anticipating a high growth and expansion of the business. A more established companies usually should have lower retention rates as their growth opportunities are less prevalent. The retention rate can be influenced by other factors as well and its is depended on the industry, macro economical condition and management style. As a general principle, if a company is reinvesting its profit and growing at a higher rate, than the investors should prefer that the business is retaining and reinvesting as much of its profit as possible. On the other heads if the company has limited opportunities for growth and the investor has better way to reinvest the money, than the investors should look for lower retention rate.

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