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Retention Ratio

Definition

Retention Ratio, also known as plowback ratio, is a financial term that refers to the proportion of a company’s earnings that is retained in the business rather than being paid out as dividends to shareholders. It is calculated by subtracting the dividend payout ratio from 1. The higher the ratio, the more earnings the company is reinvesting into itself for growth.

Phonetic

The phonetics of the keyword “Retention Ratio” is: rɪˈtɛnʃən ˈreɪʃiˌoʊ

Key Takeaways

<ol><li>The Retention Ratio is a financial metric that reflects the proportion of net income an organization chooses to keep and reinvest back into the business, instead of paying it out as dividends to shareholders.</li><li>A high retention ratio could indicate that the company is focused on growing its business, as they are reserving more earnings for reinvestment. However, it may also mean less immediate yield for investors who prefer dividend payouts.</li><li>Finally, it is important to note that just because a company has a high retention ratio, it doesn’t necessarily mean these reinvestments are effective or beneficial. It’s crucial for investors to analyze how reinvested earnings are used for a fuller understanding of a company’s financial health.</li></ol>

Importance

The Retention Ratio is a crucial business/finance term because it indicates the percentage of net income that a company retains for reinvestment in business operations after distributing dividends to its shareholders. It reflects the company’s earnings that are reinvested in the business rather than paid out in dividends. This is important for company growth, as a higher retention ratio typically signifies that management believes the company has high growth prospects, and retaining more earnings will aid in that growth. Therefore, the retention ratio provides investors with insight into a company’s growth strategy and can help determine if the company could be a profitable investment.

Explanation

The Retention Ratio is used by companies and financial analysts as a strategic tool to gauge how much of the net income is being retained, instead of being used for paying dividends or handling other expenses. It’s an indication of a company’s earnings that are not paid out as dividends but re-invested back into the business. These reinvestments could be for the purposes of debt reduction, business expansion, or capital expenditures. As such, the retention ratio provides an insight into how a company manages its earnings for long-term investments and can be particularly useful for investors looking for companies with growth potential.The ultimate goal of any business is to grow and generate higher profits, and the retention ratio is a useful reflection of that potential. The higher the retention ratio, the more the net income is being reinvested back into the business, suggesting that the company has significant growth plans. Conversely, a low retention ratio might indicate that more earnings are going towards dividends, which could mean that the company does not have much room for growth or does not want to reinvest in itself. Therefore, along with other financial metrics, the retention ratio can be a crucial factor informing investment decisions.

Examples

1. Johnson and Johnson: As a company with a long history of increasing dividends, Johnson and Johnson is a practical example of a company that uses a moderate retention ratio. The company maintains a sustainable policy of distributing about half of its profits to its shareholders and retaining the other half for reinvestment, thus showing a balanced retention ratio.2. Berkshire Hathaway: Warren Buffet’s company, Berkshire Hathaway, famously does not pay dividends and instead reinvests all of its earnings back into the company. This is an example of a company with a 100% retention ratio, as it retains all of its profits for reinvestment or to acquire other companies.3. Microsoft: Microsoft was known for its high retention ratio during the company’s growth stage. The company did not pay any dividends to its shareholders until 2003, more than 28 years after it was founded. The retained earnings were reinvested in the company to fuel growth and innovation. After the company started paying dividends, the retention ratio decreased but remained at a significant level to allow for further investment in new technologies.

Frequently Asked Questions(FAQ)

What is the Retention Ratio?

The Retention Ratio, also known as plowback ratio, is a financial term that refers to the percentage of net income that a company retains for reinvestment into the business, instead of distributing it as dividends to its shareholders.

How is the Retention Ratio calculated?

The Retention Ratio is calculated by taking the difference between the total net income and the total dividends paid out, and then dividing that amount by the total net income. The formula is: Retention Ratio = (Net Income – Dividends) / Net Income.

What does a high Retention Ratio indicate?

A high Retention Ratio denotes that the company is reinvesting a significant percentage of its profits back into the business. This could mean that the company is focused on growth, or it may not have sufficient funds to pay dividends.

How does Retention Ratio influence the growth of a company?

The Retention Ratio directly impacts a company’s growth. The more the company retains earnings, the more it can invest in opportunities to generate more income, which can lead to accelerated growth.

How does the Retention Ratio affect shareholders?

While the Retention Ratio reflects a company’s growth potential, it also indicates that shareholders may receive a smaller proportion of profits as dividends. If the company’s reinvestment strategies are successful, the shareholders could benefit from increasing share values.

Can a company have a Retention Ratio over 100%?

Yes, a company can have a Retention Ratio over 100% if it pays out more in dividends than it earns in net income.

What is the difference between Payout Ratio and Retention Ratio?

The Payout Ratio is the opposite of the Retention Ratio. It indicates what percentage of earnings a company pays out to shareholders as dividends. If you subtract the retention ratio from 1, you get the payout ratio.

Is a higher Retention Ratio always better?

A higher Retention Ratio is not always better. It depends on the company’s growth opportunities, efficiency at reinvesting, and the shareholders’ need for dividends. A higher ratio could suggest growth but might also indicate that the company doesn’t have suitable projects to invest in.or it could be dealing with financial difficulties.

Related Finance Terms

  • Dividend Payout Ratio: This is the portion of the corporate earnings that is paid out to shareholders as dividends. It has an inverse relationship with the retention ratio.
  • Return on Retained Earnings: It indicates how well the company is using its retained earnings to generate profits.
  • Earnings Per Share (EPS): This is the portion of a company’s profit allocated to each outstanding share of common stock. It ties in with the retention ratio, as the more earnings are retained, the less is distributed as dividends, affecting the EPS.
  • Capital Gains: An increase in the value of a capital asset that gives it a higher worth than the purchase price. A significant portion can be due to retained earnings which were reinvested into the business.
  • Growth Rate: The rate at which a company is expected to grow its earnings. Retention ratio is used in calculating the growth rate of a company.

Sources for More Information

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