The retention ratio reflects proportion of earnings retained by the business. These are the earnings that have not been distributed among shareholders. Instead, these earnings have been used in the business and reflected in the retained earnings section of the balance sheet. Retained earnings is a credit balance on the balance sheet. The respective credit can be in any form of the assets. These forms include cash, property, plant, equipment, inventory, and any other form of the assets.
After fulfilling the business’s operational expenses the remaining income i.e. profit can be spent in two ways. It can either be distributed among the firm’s shareholders as ‘dividends’ or it can be retained to be spent internally in the firm. Two opposite financial metrics are used to determine the percentage of profit dedicated to each purpose. These are the retention ratio and the payout ratio.
- A retention ratio, also known as the ‘plowback ratio’ or ‘net income ratio’ is used by companies or businesses to determine the ratio of profit that is withheld as ‘retained earnings’ at the end of the financial year to be reinvested into the business for its growth.
- The opposite of the retention ratio is the ‘payout ratio’ as it is used to determine the portion of profit paid out to shareholders as dividends for building strong investor relations.
The focus of this article will be on the explanation of the retention ratio and methods to calculate it.
Retention ratio Determinants
Retained earnings can be utilized in a number of ways to benefit a business. For instance, this money can be used to incorporate a new production facility to increase supply. A technological upgrade can be accomplished by investing in sophisticated equipment, machinery, and devices like AI assistants or RFID mechanisms. By putting more capital into the Research and Development (R&D) new product lines can be launched and existing products can be enhanced. Moreover, new staff can be hired to meet rising demand, and training programs can be organized for upgrading the skills of current staff. Expanding business globally through mergers, acquisitions, and FDI requires intensive capital which can be gained from retained earnings.
Further, there are different determinants of the retention ratio that include but are not limited to the followings.
Size and Age of the Company
The level of retention ratio varies from company to company depending on how well-established or new a company is. Mature companies have already accomplished most from the above-mentioned developments thus retained earnings don’t carry much weight for them. On the other hand, growing companies still have a long way to go therefore having greater retention ratios is important for them.
Nature of the Company
The retention ratio is also subject to the nature of a firm as new companies in the technology, biotechnology, finance, and e-commerce sector usually have higher retention rates while established companies in the utilities or telecommunication sector have lower plowback percentages because of the greater need to pay out dividends. This trend is observed in the example of General Electric (GE); a conglomerate in the utilities and energy sector and Apple; a high-tech manufacturer of electronic devices and software. GE annually gives dividends while Apple started distributing dividends in 2010, before that it had a 100% retention rate.
Another reason for a company to have a low retention ratio is that it could be a ‘value-based’ firm that spends a bigger portion of its earnings on charity. Or the board of directors, which is responsible for making the decision on retention ratio, would comprise greatly of stockholders who would grant themselves dividends.
Retention ratio Considerations
Just like any other financial ratio, a retention ratio is not an absolute indicator of a firm’s financial position. A high retention ratio does not always mean that a company is more growth-focused or that it will make greater profits in the future because retaining more earnings does not guarantee effective use of those earnings. This means that a company with higher plowback might just be hoarding the profits and not investing them for valuable developments. Therefore, to have an accurate analysis, the retention ratio of a firm should be observed over a period of time and then compared with that of other similar firms in the same industry.
Importance of Retention ratio
The retentions ratio is an important figure for investors who can either be growth-oriented or income-oriented. A lower retention ratio would attract income-oriented investors as they are more interested in receiving short-term gains i.e. dividends. While a higher retentions ratio would appeal to the growth-oriented investors who believe that reinvesting in the business would translate into higher stock prices in the long run.
The retentions ratio might vary for firms but it is still important to conserve at least 20% of retained earnings because firms that don’t dedicate a portion of their profit to retained earnings or don’t use their retained earnings effectively are more reliant on outside sources for taking loans or issuing shares to finance their business needs.
Retention ratio formula
Retention ratio is calculated by using the following formula:
Retention ratios = Net income – (Dividends distributed) / Net income
Retention ratio = 1 – Dividend payout ratio
If you choose the first formula, then the net income figure can be obtained from the income statement and the dividends figure appears in the equity section of the balance sheet and also in the financing section of the cash flow statement.
Suppose a manufacturing business of electronic cars has the following figures of net income, dividends, and retained earnings for the year 2020.
Net income = $10,000
Dividends = $1000
Using the second formula:
Retentions ratio = (10,000 – 1000) / 10,000 = 0.9 = 90%
Retention ratio might be higher or lower depending on the size and nature of companies but it is still a significant factor in determining business profitability, stability, and success. Therefore, the management should be unbiased in deciding on the right ratio of retained earnings and dividends to ensure profit maximization as well as good shareholder relations.
Retention ratio refers to earnings that have not been distributed among shareholders. Instead, these earnings have been used to finance the strategic and operational needs of the business.
There are different determinants of the retention ratio that include the size, nature, and age of the company. Further, a higher value of retained earnings leads to the quick availability of financing that can be used for business development and working capital management.