The profit generated by a business is divided proportionately and distributed primarily into two avenues.
A portion of it is paid out to shareholders as dividends, while the other part is retained and channelled into propagating the growth of the business. The latter of the aforementioned proportions is given by the retention ratio (RR).
It is the percentage that is retained from a company’s net profit and utilised to foster its growth in the future. Also known as the Plowback ratio, this particular portion of the company’s profit is reinvested into the company instead of being paid out to its shareholders.
Following is the retention ratio formula that is utilised to calculate the percentage of income that a company sets aside for its growth –
Retention ratio = Retained earnings of a company/A company’s net income
Or, Retention ratio = (Company’s net income – dividend payouts)/Company’s net income
To implement the first formula for the calculation of RR, one has to locate a company’s retained earnings under its shareholder’s equity portion in a balance sheet.
It is then divided by the company’s net income located at the bottom of its income statement.
The second formula, however, utilises the dividends distributed by a company to its shareholders to calculate the RR. Here, the dividends are subtracted from a company’s net income and the resultant figure is then divided by the net income to obtain the retention ratio.
The calculation of RR can be understood better with the aid of an example –
Ms. Agarwal owns a web designing business. It has been trading in the stock market for 4 years, and she wants to calculate the retention ratio of her business for these years. During year 1, Ms. Agarwal noted a net income of Rs.5000 and did not pay out any dividends. During the 2nd year, her business’ net income was Rs.8000, and she paid out dividends worth Rs.2000. In the due course of the 3rd year, the net income amounted to Rs.10,000, and she paid out a dividend of Rs.2500. During the final year, her business generated a net income of Rs.15,000 from which she paid out Rs.4000 as dividends.
Her business’ RR can, thus, be given as –
|3rd year||(10,000 – 2500)/10,000||75%|
|4th year||(15,000 – 4000)/15,000||73.3%|
Ms. Agarwal’s web design business has had a high retention ratio for four years of its operation since she chose to pay out a smaller percentage of her business’s profits as dividends to shareholders. This high earnings retention ratio denotes that she chose to retain most of her income for financing her business’s growth.
Retention and dividend payout ratio are both given by percentages of a company’s net income. The following table illustrates the points of distinction between them –
|Parameter||Retention Ratio||Dividend Payout Ratio|
|Definition||It is the proportion of a company’s income that is reinvested back into it to foster growth.||It denotes the ratio of dividends paid out by a company to its shareholders.|
|Formula||(company’s net income – dividends paid out)/company’s net income||Total dividends paid/net income|
|Indication of a business’ financial health||A high retention ratio is not a reliable indicator of a company’s financial standing.||A high dividend payout ratio is usually indicative of a company’s maturity.|
There are several factors that may contribute to a company’s high retention ratio. These include –
Retention ratio – the percentage of retained earnings for a company during a particular period is akin to an individual’s savings account. It is the cumulative profit that is kept back for the company and can be utilised for meeting a variety of requirements like working capital, business expansion, or even paying out dividends to shareholders later.
As mentioned previously, a company’s financial health cannot be established via its retained earnings. For instance, smaller businesses or start-ups usually post a higher retention ratio since they tend to retain most of their earnings and reinvest them further into their business’s R&D.
On the other hand, well-established businesses that have been operational for quite a while might have a lower net retention ratio and tend to pay their shareholders a steady dividend, each year.
Furthermore, a business might also be experiencing slow growth and not have sufficient income to distribute among its shareholders. In this case, it retains the entirety of its earnings and consequently posts a high retention ratio.
Utilising RR as a metric to gauge a company’s future growth is also dubious. RR is severely limited in this respect because a company might not choose to reinvest the amount it has retained back from its net income into the business.
Furthermore, RR also does not illustrate how effectively the retained funds are being reinvested into the business.
Thus, the usage of RR as a financial metric falls short in every aspect. It can be utilised solely by a company to account for the percentage of profit it can utilise for growth in the future.