What is Retention Ratio?
The retention ratio (also known as the net income retention ratio) is the ratio of the company’s retained income to its net income. The retention ratio measures the percentage of a company’s profits that are reinvested into the company in some way rather than being paid out in dividends.
Retention Ratio Formula
The retention ratio can be calculated by dividing a company’s retained income by its net income. The formula below shows the steps involved:
The net income figure can be found at the bottom of a business’ income statement, and the dividend figure can either be found in the shareholder’s equity section of the balance sheet or in the financing section of the cash flow statement.
The ratio can also be calculated on a per-share basis using the following formula:
Retention Ratio Example
Alice owns a software business that focuses on web design. She’s been in business for three years and wants to calculate her business’ retention ratio. In year 1, Alice’s recorded a net income of $1,000 and did not pay any dividends. In year 2, Alice posted a net income of $5,000 and paid out $500 in dividends. In year 3, Alice reported a net income of $15,000 and paid out a total of $1,000 in dividends.
Using the formula above, we can calculate the retention ratio for each period:
- Year 1: (1,000 – 0) / 1,000 = 100%
- Year 2: (5,000 – 500) / 5,000 = 90%
- Year 3: (15,000 – 4,000) / 15,000 = 73%
In the example above, we can see that the retention ratio for Alice’s is going down each year. It is because net income is rising each year and dividends are rising by a proportionally larger amount, leading to a downward trend in the ratios.
The change may be indicative of the business’ lack of focus on growth as it chooses to give out its earnings to shareholders rather than reinvest them into the business. To understand whether it is a good or bad thing, we must compare the figures to the ratios from its competitors in the same industry.
Interpreting the Retention Ratio
A high retention ratio may not always be indicative of financial health. To better understand the retention ratio, we must first understand the company that we are calculating the ratio for.
Smaller, newer companies will typically report lower retention ratios. Smaller businesses tend to prioritize business development and investments in research and development (R&D), which can be a reason why they are more likely to retain their earnings rather than distribute them as dividends. A small business may also be experiencing slow sales in the early stages of business, which would mean that there is less income to distribute to shareholders, thus resulting in a higher retention ratio.
Larger, more mature companies will usually post lower retention ratios as they are already quite profitable and do not need to invest as heavily in R&D. Thus, larger companies may pay investors consistent dividends as it may be the best way of generating shareholder wealth at later stages.
As with any financial ratio, there is not much meaning behind a single number. In order to draw meaningful insights, analysts must consider the ratio in relation to the ratios of similar companies operating in the same industry. It will enable us to more easily compare one company to another in terms of their earnings retention.
Ratios can also be looked at over a period of time in order to observe trends and year-over-year changes in the metric. It will enable us to evaluate changes in the company’s performance over a given time interval.
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