Retention Ratio: Definition, Formula, Limitations, and Example (2024)

What Is the Retention Ratio?

The retention ratio is the proportion of earnings kept back in a business as retained earnings. It 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.”

Understanding the Retention Ratio

Companies that make a profit at the end of a fiscal period can use the funds for a number of purposes. A company can pay the entire profit to shareholders as dividends, it can retain all of it to reinvest in the business for growth, or it can do some combination of both. The portion of the profit that a company chooses to save for later use is called “retained earnings.”

Retained earnings are similar to a savings account, because the company is holding the money with the intent to invest it; it hasn’t actually spent it yet. The retention ratio is expressed as a percentage, comparing the money on hand for reinvestment with the company’s total net income. It helps investors determine a company’s future viability.

That viability is tied to how a company uses its retained earnings. If it hoards them instead of investing them in new equipment, technology, or expanding product lines, or if it pays all of them out as dividends, earnings growth might suffer. The bottom line is that unless a company uses its retained earnings effectively, it has an increased likelihood of taking on additional debt or issuing new equity shares to finance growth.

New companies typically don't pay dividends, as they need capital to finance their growth. Established companies usually split the difference, paying a portion of their retained earnings out as dividends while also reinvesting some funds back into the company.

How to Calculate the Retention Ratio

There are two formulas used to calculate the retention ratio. The first involves locating retained earnings in the shareholders' equity section of the balance sheet, then dividing it by the company’s net income figure, which can be found on the bottom line of its income statement. It is expressed as:

$\begin{aligned} \text{Retention Ratio}=\frac{\text{Retained Earnings}}{\text{Net Income}} \end{aligned}$RetentionRatio=NetIncomeRetainedEarnings​​

The second does not use retained earnings. Instead, it subtracts dividends distributed, found on the company’s statement of cash flows in the financing section, from net income, then divides the result by net income. It is expressed as:

$\begin{aligned} \text{Retention Ratio}=\frac{\text{Net Income} -\text{ Dividends Distributed}}{\text{Net Income}}\\ \end{aligned}$RetentionRatio=NetIncomeNetIncome−DividendsDistributed​​

Of course, net income minus dividends distributed equals retained earnings, so they really are the same formula.

Special Considerations

The retention ratio is typically higher for growth companies that are experiencing rapid increases in revenues and profits. These are often in sectors such as technology and biotechnology. 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.

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 generous dividend, the retention ratio is typically quite low.

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.

Limitations of Using the Retention Ratio

The retention ratio doesn’t tell you how much of its retained earnings a company is choosing to put back into the company. Also, a retention ratio doesn’t calculate how the funds are invested or if any investment back into the company was done effectively.

It’s best to utilize the retention ratio in concert with other financial metrics to determine how successfully a company is deploying its retained earnings. It’s also important to compare the results with companies in the same industry and monitor the ratio over several quarters to determine if there’s any trend.

Real World Example

Below is a copy of the balance sheet for Meta (META), which owns Facebook and Instagram, as reported in the company’s annual 10-K for 2018, filed on Jan. 31, 2019, when it was still known as Facebook, Inc.

• In the shareholders’ equity section, the company’s retained earnings totaled $41.981 billion for the period (highlighted in green).
• The company’s income statement (not shown) posted a profit or net income of $22.112 billion for the same period.
• You calculate its retention ratio as: $41.981 billion ÷ $22.112 billion = 1.89, which makes the ratio 189%.

The reason the retention ratio is so high is that the company accumulated profit and didn’t pay dividends. As a result, it had plenty of retained earnings to invest in its future. A high retention ratio is very common for technology companies.

The Bottom Line

A company’s retention ratio tells you the percentage of its net income that the company has chosen to keep rather than distribute to shareholders as dividends. It’s used by potential investors to indicate a company’s financial health and possible future viability. It’s best employed in concert with other financial metrics, as it doesn’t tell you how much of those earnings a company has reinvested in itself, nor does it indicate if such investment has been done successfully.