There are several ways to assess a company’s growth and predict its financial future. One such measurable financial metric is the retention ratio, which shows how much money a company is reinvesting in the business. If you must measure this ratio for a company, it may be helpful to understand some key concepts to ensure you’re calculating this metric correctly.
A company’s retention ratio plays a significant role in valuation, as it helps investors determine how much of the company’s profit can be reinvested in future growth. There are many reasons a company may have a high or low retention ratio. For example, a value-based company may have a low retention rate because it gives a large portion of its earnings to charity.
On the other hand, a high-growth company may be rapidly reinvesting funds into new products or services while deferring payouts to shareholders. All of these factors are worth considering when performing a retention ratio analysis.
Understanding the concept of Retention Ratio
The retention ratio is the proportion of earnings kept back in the business as retained earnings. The retention ratio refers to the percentage of net income that is retained to grow the business, rather than being paid out as dividends. It is the opposite of the payout ratio, which measures the percentage of profit paid out to shareholders as dividends.
The retention ratio is also called the plowback ratio.
Companies that make a profit at the end of a fiscal period can use the funds for several purposes. The company’s management can pay the profit to shareholders as dividends, they can retain it to reinvest in the business for growth, or they can do some combination of both. The portion of the profit that a company chooses to retain or save for later use is called retained earnings.
Retained earning is the amount of net income left over for the business after it has paid out dividends to its shareholders. A business generates earnings that can be positive (profits) or negative (losses).
Retained earnings are similar to a savings account because it’s the cumulative collection of profit that’s retained or not paid out to shareholders. Profit can also be reinvested back into the company for growth purposes.
How to calculate the Retention Ratio
Here are the two formulas for calculating a company’s retention ratio:
Formula using a balance sheet
When calculating a company’s retention ratio, you may have access to its balance sheet, which lists a company’s assets, liabilities and equity. In this case, you can locate the company’s retained earnings on the balance sheet and find its net income figure on the income statement, which shows a company’s revenue and expenses. When you have both figures, you can divide the retained earnings by the net income.
The formula looks like this:
Retention ratio = Retained earnings / Net income
For example, if you want to find the retention ratio for a company with $200,000 in net income and $150,000 in retained earnings, you’d calculate the following:
Retention ratio = $150,000 / $200,000 = 0.75 = 75%
In this case, the company’s retention ratio is 75%.
Formula without a balance sheet
When finding a company’s retention ratio without a balance sheet, you need to first calculate the company’s retained earnings. To do this, subtract the dividends that a company distributes during a fiscal period from its overall net income. Then divide that number by the total net income. The formula looks like this:
Retention ratio = (Net income – Dividends) / Net income
For example, if you’re determining the retention ratio for a company with $500,000 in net income and $350,000 in dividends, you’d calculate the following:
Retention ratio = ($500,000 – $350,000) / $500,000 = $150,000 / $500,000 = 0.30 = 30%
In this case, the company’s retention ratio is 30%.
Real World Example
Below is a copy of the balance sheet for Meta (META), formerly Facebook, as reported in the company’s annual 10-K, which was filed on Jan. 31, 2019.
- In the shareholders’ equity section, the company’s retained earnings totaled $41.981 billion for the period (highlighted in green).
- From the company’s income statement (not shown) it posted a profit or net income of $22.112 billion for the same period.
- Calculate its retention ratio by the following: $41.981 billion / $22.112 billion, which equals 1.89 or 189%.
The reason the retention ratio is so high is that the tech company has accumulated profit and didn’t pay dividends. As a result, the company had plenty of retained earnings to invest in the company’s future. A high retention ratio is very common for technology companies.
How is the retention ratio used in business?
Businesses may use retention ratios differently, depending on their industry and longevity. For example, new technology businesses might have higher ratios if they prioritize spending money on research and development over paying dividends to shareholders. These companies may also have lower profits at first.
Older and more established companies typically have lower ratios because they require less investment in research and development to be successful. These companies may find it more beneficial to pay larger dividends to shareholders who own shares of a company’s stock.
Many companies use their retention ratio as one metric within a series of other financial calculations to help them define trends for the company and predict future growth. In some cases, it’s helpful for companies to consider this ratio in combination with the dividend payout ratio to plan for future growth.
Special Considerations
The retention ratio is typically higher for growth companies that are experiencing rapid increases in revenues and profits. A growth company would prefer to plow earnings back into its business if it believes that it can reward its shareholders by increasing revenues and profits at a faster pace than shareholders could achieve by investing their dividend receipts.
Investors may be willing to forego dividends if a company has high growth prospects, which is typically the case with companies in sectors such as technology and biotechnology.
The retention rate for technology companies in a relatively early stage of development is generally 100%, as they seldom pay dividends. However, in mature sectors such as utilities and telecommunications, where investors expect a reasonable dividend, the retention ratio is typically quite low because of the high dividend payout ratio.
The retention ratio may change from one year to the next, depending on the company’s earnings volatility and dividend payment policy. Many blue chip companies have a policy of paying steadily increasing or, at least, stable dividends. Companies in defensive sectors such as pharmaceuticals and consumer staples are likely to have more stable payout and retention ratios than energy and commodity companies, whose earnings are more cyclical.
Benefits of calculating the retention ratio
There are many benefits of using a retention ratio in business, some of which include:
Evaluating a company’s growth
A higher retention ratio can indicate substantial growth in a company. Companies with higher ratios, particularly smaller and newer companies, may see rapid increases in revenue and profits initially. Because a company’s ratio can fluctuate from year to year, it’s important to consider other financial metrics besides this ratio to have a complete understanding of a company’s long-term development.
Measuring a company’s reinvestment
A company’s retention ratio can show how much money a company is reinvesting in its operations. A larger reinvestment can be a sign of financial stability for companies. This metric can show that a company makes enough profit to put substantial retained earnings back into the business, in addition to any funding it receives from creditors or investors.
Understanding annual changes and trends
By calculating their retention ratio each year, companies can determine any trends in their overall growth. It also allows a company to see how changes that it implements over the year affect its annual performance. This insight can help a company evaluate whether it’s using appropriate strategies to meet its financial goals.
Forecasting a company’s future
The retention ratio can help anticipate how quickly a company may grow in the future. For companies to operate and grow, they must retain some portion of profits each year. A high ratio can help companies encourage investors to invest money or other capital into the business with the expectation of future profits.
Comparing a company’s financial performance
A company may find it helpful to compare its retention ratios with those of other companies in its industry to measure its own financial status. They may monitor these ratios over several fiscal quarters to gain a more complete understanding of how they compare with their competitors in terms of financial growth.
This evaluation can help company leaders decide to make significant changes that could improve the company’s competitive outlook.
Limitations of the Retention Ratio
There are several limitations to the retention ratio worth considering.
1. The retention ratio does not calculate how funds are used. Though the retention ratio does help investors determine a company’s reinvestment rate, it does not show how it is using the funds. You’ll need to look at other financial metrics to determine how a company is reinvesting its retained earnings and to what extent they have been successful.
2. The retention ratio is not always an indicator of growth. A mature company with a significant amount of retained earnings will have a high retention ratio. It would be easy to assume that this must mean they’re a high-growth company. However, the company may not be reinvesting its retained earnings into expanding business operations.
3. The retention ratio is only useful in comparing companies of similar scale. Emerging companies often do not have the same cash flow as more mature, established companies and may be more likely to have a low retention ratio by comparison. It’s only useful to compare retention ratios among companies within the same industry and at a similar stage of growth.
4. A higher retention ratio is not always a sign of financial health. Growth investors will look at a company’s retention ratio to determine whether the company can reinvest funds for the sake of growth. These investors are operating on the principle that a high retention rate indicates a potential rise in stock price. However, this is not always the case as sometimes company management retains more of its earnings in anticipation of impending financial hardships.
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