The Retention Ratio Guide: Balancing Growth and Dividends

Summary:

Retention ratio is an essential indicator of a company’s financial strategy. It allows you to determine whether a company is putting back money into the business for growth or distributing dividends to shareholders. By calculating the retention ratio in two simple ways, you can gain valuable insights. Coupling this with other financial metrics will give you a comprehensive view of the company. But be cautious, as there are a few limitations you must be wary of.

At the end of a fiscal year, a company that makes profit can use the funds for a variety of purposes. The management can decide to retain it to reinvest in the business for growth, pay the profit to shareholders as dividends, or do a combination of both.

Here’s where retention ratio comes in. An often-overlooked figure, coupled with other factors, the retention ratio can give you a glimpse into a company’s financial strategy. Beyond the numbers, retention ratio exhibits the intentions of a company, whether it provides generous returns to its investors or getting ready for aggressive expansion.

Let’s delve further into retention ratio and see how you can calculate it, the limitations and a few examples for better understanding.

Definition of retention ratio

Retention ratio is a financial ratio which shows the percentage of net income that a business retains for growth, after paying it out as dividends to shareholders. It’s also called plowback ratio, and it’s the opposite of payout ratio. Retained earnings are considered as net income and are reflected in the income statement.

Formula to calculate retention ratio

There are two primary ways to calculate retention ratio.

1. Retention ratio = Retained earnings / net income

Here, the company needs to locate their retained earnings in the shareholder's equity portion of the company’s balance sheet. Next, find the net income in the company’s income statement. Once you’ve found both figures, divide the retained earnings by the net income.

For example, to calculate the retention ratio of Company XYZ with a net income of Rs. 60,00,000 and retained revenue of Rs. 15,00,000, you have to divide the retained earning of  Rs. 15,00,000 by the net income of Rs. 60,00,000 = 0.25. So, the retention ratio is 25%.

2. Retention ratio = (Net income – dividends distributed) / net income

This formula will help if you are unable to find the retained earnings in the financial statements. All you have to do is subtract the net income from distributed dividends and then divide the figure by the net income.

For example, to calculate the retention ratio of Company XYZ with a net income of Rs. 7,50,000 and paying dividends of Rs 4,00,000, the calculation is Rs. 7,50,000 − Rs. 4,00,000) / Rs. 7,50,000 = 0.467. So, the retention ratio is approximately 46.7%.

Limitations of retention ratio

With retention ratio, there are certain limitations to consider.

1. Oversimplification

While the retention ratio does help investors determine a company's reinvestment ratio, it doesn’t show how they use their funds. In actuality, the business can use the retained earnings for a variety of purposes like share buybacks, acquisitions, debt reduction, etc. So, a high retention ratio doesn’t necessarily mean the business is heavily investing in growth. It also indicates other uses of retained earnings.

2. Dividend policy variation

Dividend policies vary across sectors and industries. For instance, some industries like utilities usually have high dividend payouts, while tech companies reinvest their earnings for growth. So, if you compare retention ratios across industries, it may not exhibit meaningful insights. Various business strategies and sector norms have an influence.

3. Reliant on market conditions

Financial crises, economic downturn and other external factors affect the company’s retention ratio. During challenging economic times, a company may decide to create a financial cushion by retaining more earnings.

4. Lack of context

When you view retention ratio in isolation, it lacks context. For a more comprehensive analysis of a business, you must take other financial metrics into account. This includes overall financial health, cash flow, debt levels, etc.

5. Shareholder expectations

This method doesn’t account for shareholder expectations. For instance, growth-oriented investors may find a company with a high retention ratio attractive while income-focused shareholders prefer a company with a low retention ratio. So the retention ratio for a company depends on its investors and whether it meets their expectations.

6. Earnings quality

A high retention ratio isn’t necessarily an indicator of high-quality earnings. Sometimes companies temporarily boost their retention ratios through one-time gains or accounting adjustments. For a comprehensive analysis, you must evaluate the sustainability and consistency of earnings.

Examples of retention ratios

Here are two practical examples that can help you learn more about calculating a business's retention ratio:

Example 1 - Using financial statements

A software company, Company B, has shareholders from across India. The company earned Rs 20,00,000 in net income in the first fiscal year. After reviewing the balance sheet, they determined Rs. 10,00,000 as retained earnings. Therefore, after paying dividends, the company was left with a net income of Rs. 10,00,000.

To calculate the retention ratio, divide the retained earnings by the net income, which is Rs. 10,00,000 / Rs. 20,00,000 = 0.5 or 50%. You can conclude that after distributing its dividends, the company reinvested 50% of its net income.

Example 2 - Without using financial statements

A fashion brand, Company R is readily expanding operations across India. Due to its promising growth aspects, several shareholders opt not to receive dividends. This allows the company to allocate more funds for internal operations.

The company earned Rs 50,00,000 in net income in the first fiscal year. They distributed dividends of Rs. 35,00,000 to their shareholders.

To calculate the retention ratio, you subtract the dividends paid from the net income, which is Rs. 50,00,000 - Rs. 35,00,000 = Rs. 15,00,000 then divide by the net income, which is Rs. 15,00,000 / Rs. 50,00,000 = 0.3 or 30%. This shows that 70% was distributed as dividends to shareholders and 30% was used by the business for their expansion.

The bottom line

It’s crucial to understand the working dynamics of retention ratio for stakeholders and investors as it helps gauge the company's financial health. But remember, retention ratio is just one piece of the puzzle. For complete financial analysis, you need to consider a plethora of factors to make a sound investment decision.