Key Takeaways
- Retention Ratio measures the ratio between a company’s retained earnings and it’s net income.
- Retention ratio can also be calculated on a ‘per-share’ basis.
- A higher retention ratio indicates to the company’s management that the cash can be used internally to ensure a greater rate of return in comparison to the cost of capital.
- A lower retention rate indicates that earnings are being paid to investors in the form of dividends.
What is Retention Ratio?
The retention ratio measures the ratio between company’s retained earnings and its net income; and is used to evaluate the percentage of company’s profit that is potentially reinvested back into the company instead of being paid out as dividends to investors.
How to calculate Retention Ratio?
Formula for calculating Retention Ratio is as follows:
Retention Ratio = (Net income – Dividends) / Net income
Information regarding net income can be found in the company’s income statement and dividends can be found in the balance sheet under ‘shareholder’s equity’, or in the cash flow statement under financing section.
The alternate way to calculate retention ratio is on a ‘per-share’ basis. The following formula is used for this:
Retention Ratio = (Earnings per Share – Dividends per Share) / Earnings per Share
Understanding Retention Ratio
The retention ratio talks about the portion of net income retained to be invested back into the business. A higher retention ratio indicates to the company’s management that the cash can be used internally to ensure a greater rate of return in comparison to the cost of capital. A lower retention rate indicates that earnings are being paid to investors in the form of dividends.
Investors use this ratio to figure out if the company or the business is reinvesting back itself to improve its operations which will eventually lead to an improvement in their stock price. However, it is important to note that it’s not necessary for the companies to reinvest back in their operations. They may also just be saving up for any unforeseen crucial times.
A decrease in the ratio can indicate that the management of the business does not think it’s profitable for the company to pursue investing in themselves because the growth they want may end up being more costly than the returns they may gain from it. This can further indicate a potential increase in the investors that are looking to own the company’s stock since the company would be giving out dividends to its shareholders.
