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What is the Retention Ratio?

Synopsis:

A company’s retention ratio is one of the simplest yet effective indicators of its financials and strategy. If a company retains a large portion of its net profit, it usually Read more..needs to reinvest its earnings in its business for growth and expansion. At times, a company retains a large portion of its earnings to pay an obligation, like a loan, as well. Conversely, companies with a low retention ratio distribute most of their earnings as dividends to their shareholders. Such firms do not expect to grow rapidly; hence, their capital requirements are low.


Retention ratio is one of the most important metrics to analyse the financials of a company. It shows the percentage of net profit retained by a company. When a company earns a net profit, it can either distribute it as dividends to its shareholders or it can retain it without providing dividends.

Typically, firms retain net profit to reinvest in their business or to pay off an obligation. Hence, if a company retains a large portion of its earnings, it could mean that it wants to invest in its operations or it has to pay an obligation like a loan.

That said, a company will retain a considerable portion of its net profit only if it sees scope for growth and expansion. Hence, if it is not expected to grow at a high rate, it usually means that its capital requirements are not high.

So, it does not have to retain a lot of its earnings. Such companies tend to distribute a large portion of their earnings as dividends to their shareholders. Now that you know what the retention ratio is, let us discuss how to calculate it.

How to Calculate Retention Ratio?

Calculating the retention ratio is very easy, as it involves basic steps and two or three data points from a company’s financial statements.

The first formula that can be used to calculate the retention ratio is as follows:

Retention Ratio = Retained Earnings / Net Profit

You can take the data on retained earnings from the shareholder’s equity section of a company’s balance sheet and the data about net profit from its profit & loss statement (also known as income statement).

There is another formula as well to calculate the retention ratio, which is provided below:

Retention Ratio = (Net Profit – Dividends Distributed) / Net Profit

You can find the dividends distributed by a company in the statement of changes in equity or in the cash flow statement.

Let us say that a company earns ₹ 1 crore as net profit in a year and distributes ₹ 75 lakh as dividends. You can calculate its retention ratio as follows:

= (₹ 1 crore - ₹ 75 lakh) / ₹ 1 crore = 25%

A retention ratio of 25% shows that the company is distributing a substantial part of its earnings as dividends to its shareholders. This indicates that it does not need to plough back much of its earnings to grow its business. Hence, the scope for growth and expansion in its business could be low.

Importance of Retention Ratio in Financial Analysis

Interpreting a company's retention ratio can help you gain interesting insights into its financials and strategy. A firm with a high retention ratio retains a large part of its earnings. This is usually the case with companies that are growing at a high rate.

Such companies need funds to invest in their business. Rather than borrowing from outside or raising more equity that requires stake dilution, such companies prefer to reinvest their earnings into their business. Most such companies are in sectors that experience exponential growth.

That said, a company may retain a huge portion of its earnings even to pay its obligations, like a loan. Hence, you should always check the root cause of a high retention ratio.

On the other hand, a company with a low retention ratio tends to distribute a large portion of its net profit as dividends to its shareholders. Often such companies do not expect to grow rapidly, which means they do not have to reinvest their earnings into their business. Such companies are mostly found in traditional industries, which do not grow at a high rate.

While analysing a firm’s retention ratio, you must compare it with other firms in its industry. This is because the average retention ratio may vary across industries.

Retention Ratio vs. Dividend Payout Ratio

You should understand the difference between the retention ratio and the dividend payout ratio to analyse a company’s financials well. Hence, please refer to the table given below:

Criteria

Retention Ratio

Dividend Payout Ratio

Meaning

This ratio shows the percentage of net profit retained by a company.

This ratio represents the portion of earnings paid as dividends to shareholders by a firm.

What insights does it provide?

It shows you whether a company has a high scope for growth or whether it has to pay a huge obligation.

It shows you the extent to which a company can reward its shareholders through dividends. If you want to invest in a firm purely for dividends, you should check its dividend payout ratio.

Investors Preference

A high retention ratio is preferred by investors who want to invest in companies with a high growth potential.

A high dividend payout ratio is preferred by investors who want to invest in a firm for its dividend-paying capacity.

What does it show about an industry?

Industries which grow at a high rate tend to have companies with a high retention ratio because they need to plough back most of their earnings into their business for growth and expansion.

Mature industries which do not grow at a high rate and which have stable cash flows tend to have companies with a high dividend payout ratio. Such industries do not need to invest their earnings back into their business; hence, they can increase their dividend payout.

Factors Influencing Retention Ratio

It is important to understand the factors that influence a company’s retention ratio to interpret it thoroughly. So, here are those factors:

a) Potential for growth: A company with a high growth potential needs capital, which can be supplied through its retained earnings. Hence, such firms tend to have a high retention ratio. Conversely, a firm with a low growth potential tends to have a low retention ratio.

b) Industry characteristics: The characteristics of an industry tend to impact a firm’s retention ratio. For example, if an industry needs a lot of investment in research and development (technology and pharma are examples), then firms in such an industry may retain a large portion of their earnings because they need funds to invest in R&D.

c)  Management strategy: An aggressive management which is constantly looking out to grow by acquiring another firm or expanding into a new market will need more funds. Hence, a company with such a management is likely to have a high retention ratio.

Conclusion

Whether you are a new investor who is about to open a demat account or an experienced investor, the retention ratio is an important indicator for you. Hence, you must know how to use it. Apart from learning its formula, you must also know how to use it based on the characteristics of a business.

For example, the ideal retention ratio could vary across industries. Mature industries may have a low retention ratio and emerging industries may have a high retention ratio. Hence, you should have knowledge about an industry to interpret the data related to retention ratio.

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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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