Understanding Retention Ratio

The retention ratio indicates how much the percentage of a company's earnings is credited back in business rather than being paid out as dividends to shareholders. Companies retain some portion of their profits for development, growth, and expansion.

The retention ratio is opposite to the Payout Ratio. Where Retention ratio measures the retained percentage of the company earnings, and the Dividend Payout Ratio measures the percent of profit paid to the shareholders as dividends. The Retention Ratio indicates how much the company plows back its earnings for growth and expansion, so it is also known as Plowback Ratio.

The formula to derive Retention Ratio

Net Income - Net Profit or Net Income is measured by sales minus the Cost of goods sold, general and administrative expenses, operating expenses, other expenses, depreciation, interest, taxes, etc. Net Income is found in the Income statement of the company.

Dividend Paid - It is part of the company's earnings paid out as dividends to its shareholders, and it is found in the cash flow statement.

Example of Retention Ratio: For the financial year, Havells India reported Net Income as Rs. 1044.31 Cr., and Dividend Paid as Rs.187.80 Cr. The value as per the Formula (Retention Ratio = Net Income - Dividend Paid / Net Income) is calculated as (1044.31 - 187.80 / 1044.31) = 0.82.

Key Highlights

The retention ratio indicates how much the company retains its earnings to reinvest in operations, and it is calculated by subtracting Net Income and Dividend Paid divided by Net Income.

Growing companies retain a high portion of their earnings back into business for growth and expansion.

The retention ratio is inverse to the Payout Ratio.

The sum of the retention ratio and dividend payout ratio should be a total of 100%.

While looking at the Retention Ratio, the following points should also take into consideration:

Growing companies retain a high portion of their earnings back into business for growth and expansion.

The ideal range of this metric depends upon the perspective of investors. The size of this ratio attracts different types of investors. Income-oriented investors look for companies with a low retention ratio, and goal-oriented investors look for a high ratio.

A high retention ratio indicates that the company is reinvesting its earnings back into the business to expand its net income, growth, and expansion.

Companies that are still growing or have less cash flow are likely to plow back a high portion of their earnings or all earnings back into the business to reinvest in operation.

How to use Retention Ratio effectively

Growth-oriented investors usually look for a high ratio because the company may not be paying high dividends or not at all but growing, so there are high chances that the company may give dividends in the future.

Growth-oriented investors usually look for a high retention ratio because the company may not be paying dividends in the present or paying but in less amount and retaining its more portion for reinvestment in operations and growing continuously, may give dividends in the future. A higher Retention Ratio is not always good because we have to check different dilemmas. The retention ratio of a particular company is high, but its net profit is decreasing over a period is also a not good sign.

Income-oriented investors usually look for companies that have a low retention ratio. It indicates that the company is retaining a minimum portion of its earnings and paying the maximum to shareholders as dividends.

The sum of the retention ratio and dividend payout ratio should be a total of 100% or 1.

For better analysis, we must look at other financial metrics with retention ratio like Dividend Payout Ratio, Earnings Yield, Enterprise Value to Revenue, Free Cash Flow to Revenue, etc.,