The plowback ratio is used to identify the earnings that are retained for business after paying the dividends. It is used to calculate the profit that can be reinvested in the business after paying dividends. Plowback meaning is reinvesting profits in a business.It is a crucial ratio used by accountants to understand how much money can be reinvested for the growth of the business. Without this ratio, companies won’t be able to identify the amount left after paying dividends.
Investors also use the plowback ratio to identify how easily a firm would be able to pay dividends. The higher the ratio, the better it is for the company if it is growing at a higher pace. But if the case is otherwise and the company is growing at a slower rate, then a high plowback ratio might be a symbol of counter productiveness. This analysis is highly significant when comparing different companies from the same industry. It gives a realistic view of where the company stands in comparison with its competitors.
What is plowback ratio formula?
It is calculated by dividing dividends per share with Earnings per Share and then subtracting it from 1. Plowback ratio symbol can be represented as,
Plowback ratio = Dividend per share/Dividend per share
Plowback ratio example
To better understand, how the plowback ratio is calculated let’s consider an example. Suppose a business pays out dividend per share of $1.00 and that earnings per share are $2.00. The retention ratio would be calculated as,
Plowback ratio = ½ =50%
So, the company’s retention ratio is 50%. Through this figure, the investors can estimate whether the company will be able to pay dividends or not.
Plow back Vs Retention Ratio
Plowback ratio and retention ratio are the same. The retention ratio is the percentage of net income that is to be retained for the business. However, the opposite of the plowback or retention ratio is the “payout ratio”. The payout ratio measures the percentage amount of net income paid out as dividends to shareholders.
This symbolizes that the definition of payout period is exactly the opposite of the retention ratio. Hence, both the ratios are the same, but the payout ratio is the opposite. Plowback ratio in relation to payout ratio can be calculated as,
Plowback ratio = 1 – payout ratio
Suppose a business’s payout ratio is 30%. Then plowback ratio would be 70%
Implications of the plow-back ratio
The same value of retention ratio can have different impacts on the investors. For example, if the investor is income-oriented, he would like to invest in a company with a low plowback ratio because most of the earnings would be used to pay dividends. On the contrary, if the investor is growth-oriented, he will be attracted to a company with a high retention ratio because the money would be used for the growth of the business, and ultimately the stock price will increase.
When a business is growing fast all the possible funds would be used to increase fixed assets or will be used as working capital. That is why a higher ratio is attractive when the business is growing fast. While if the case is otherwise, the business would not be able to use the funds in fixed assets investment or working capital rather it would be used to return cash to investors. Hence, the higher ratio will not be attractive if the business is growing at a slower pace.
Similarly, the value of the retention plowback ratio has many other implications. For example, if the value has reached 0%, it means that the company would not be able to reinvest any money in the business and all the funds will be used to pay dividends. If the value of the retention ratio is 100%, it implies that the company uses all of its net income in the business and does not pay any dividends.
Generally, a higher retention ratio indicates favorable economic conditions for the business and it is a sign that the business’s management is focusing on business growth. However, a low retention ratio is generally a kind of warning sign in terms of future business growth. It also implies low satisfaction for the current cash holdings.
Plowback ratio and ROE
Plowback ratio and return on equity (ROE) are used together for the calculation of sustainable growth. Let the retention ratio is 50 percent as calculated in the above example, and the return on investment is 8 percent. So it will give a sustainable growth of 4 percent by multiplying both Return on investment and plowback ratio.
To calculate the corporation growth of any company, the first step is to determine the return on equity. The return on equity is the profit that is expressed as a percentage of shareholders’ equity. Information about it can be gathered from the annual report of the company within the statement of shareholder’s equity.
Plowback ratio drawbacks
The earnings per share are not equal to cash flow per share and this is the major drawback of plow-back ratio. This is because the amount of cash available to be paid out as dividends doesn’t equal the earnings. This symbolizes that the board of directors of the company will not always have enough money to be paid as dividends. So, ultimately this can be a cause of conflict among shareholders.
Final word
From the above discussion, it can be extracted that the plowbacks ratio is used for two main purposes. The first is to assess how well the company is able to pay its dividend. The second is to know about the funds that the company can reinvest for the growth or maintenance of the business.
We have also discussed how the retention ratio and return on investment can be used to determine the corporation’s growth. Moreover, the retention ratio and plow-back ratio are the same as they both explain the percentage of net income that can be re-invested which is contrary to the payout ratio.
