What is the retention ratio?
The retention ratio is simply the ratio of retained earnings to net income. A higher retention ratio indicates that more money is being put into the business rather than being paid out as dividends. The retention ratio is also called the “retention rate” and the “plowback ratio.”
How is the retention ratio calculated?
It is calculated by subtracting dividends from net income, thus calculating retained earnings, and dividing this figure by net income.
- Retention Ratio = (Net Income – Dividends) / Net Income
For instance, if net income is $10 million and dividends are $5 million, the retention ratio is 0.5 [ ($10 million – $5 million) / $10 million = 0.5].
Why are investors interested in the retention ratio?
In theory, a company with a high retention ratio can grow more quickly because it has more capital to spend on all aspects of its business.