Retention ratio
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Retention ratio is a measure of a company's ability to retain earnings for reinvestment in the company. It is calculated by dividing the amount of net income retained by the amount of net income earned in a given period. This ratio helps to measure how much of the company's profits are being reinvested back into the company, rather than being paid out as dividends or used to pay off debt.
The higher a company's retention ratio is, the more money the company is able to reinvest in itself and the more likely it is to grow. This can be beneficial in the long term as it allows the company to fund new projects and research and development, which can lead to higher profits in the future. Conversely, a low retention ratio can indicate that the company is paying out too much of its earnings as dividends or is using too much of its profits to pay down debt, which can limit its potential for growth.
Example of Retention ratio
Let's assume a company had a total net income of $500,000, and at the end of the period retained $200,000 of that income. The company's retention ratio would be calculated as follows:
Retention ratio = $200,000/$500,000 = 40%
In this example, the company's retention ratio is 40%, which means that 40% of the company's net income was retained and reinvested in the company. This is a relatively high retention ratio and suggests that the company is reinvesting a significant portion of its profits back into the business.
Formula of Retention ratio
The formula for calculating the Retention ratio is:
The retention ratio is expressed as a percentage and measures the proportion of a company's profits that are retained and reinvested back into the company. A high retention ratio indicates that the company is investing a large amount of its profits back into the company, whereas a low retention ratio indicates that the company is paying out a lot of its profits as dividends or using them to pay off debt.
When to use Retention ratio
Retention ratio can be used to measure the financial health of a company. It can provide investors with an indication of how well the company is reinvesting its profits and can be used to compare the retention ratios of different companies in the same industry. It can also be used to analyze the company's dividend policy, as companies with higher retention ratios tend to have lower dividend payouts. Finally, it can be used to assess the company's ability to generate future profits and fund new projects.
Types of Retention ratio
- Operating Retention Ratio: The operating retention ratio is calculated by dividing the amount of earnings retained from operations by the amount of earnings generated from operations. This ratio helps to measure how much of the company's operating profits are being reinvested back into the company.
- Financial Retention Ratio: The financial retention ratio is calculated by dividing the amount of earnings retained from financial activities by the amount of earnings generated from financial activities. This ratio helps to measure how much of the company's financial profits are being reinvested back into the company.
- Total Retention Ratio: The total retention ratio is calculated by dividing the total amount of net income retained by the total amount of net income earned. This ratio measures the overall ability of the company to retain its earnings for reinvestment in the company.
Steps of Retention ratio
- Calculate the Net Income Retained: This is the amount of earnings that the company has kept rather than paying out as dividends or using to pay down debt.
- Calculate the Net Income Earned: This is the total amount of earnings that the company has earned in a given period.
- Divide Net Income Retained by Net Income Earned: This will give you the company's Retention ratio, which can be used to measure how much of the company's earnings are being reinvested back into the company.
Advantages of Retention ratio
There are several advantages to using the retention ratio to evaluate a company's financial performance:
- It is a simple and straightforward measure to calculate, requiring only two pieces of information.
- It is a good indicator of a company's ability to reinvest profits and grow in the long term.
- It is an indication of how well the company is managing its finances and how it is using its profits.
Disadvantages of Retention ratio
Despite the advantages of using retention ratio, there are a few drawbacks that should be noted:
- It does not take into account any changes in earnings or profitability over time.
- It does not take into account any external factors or events that may affect the company's finances.
- It does not provide any insights into the company's efficiency and effectiveness in using its retained earnings.
The retention ratio is a useful tool for measuring a company's reinvestment of profits, however, it does have some limitations. Firstly, the ratio does not take into account the amount of money a company is earning from any investments it may have made. Secondly, it does not consider the amount of money a company is spending on research and development or any other expenses related to growth. Finally, the ratio does not factor in the amount of money a company is using to pay off debt or to pay taxes.
- Sustainable growth rate: This is a measure of the maximum rate of growth that a company can sustain without having to raise additional capital. It is calculated by dividing the return on equity by the retention ratio.
- Payout ratio: This is a measure of the amount of earnings that a company pays out as dividends to its shareholders. It is calculated by dividing the amount of dividends paid out by the amount of net income earned in a given period.
Retention ratio is an important measure of a company's ability to retain earnings and reinvest in itself, which can lead to long-term growth. It is an important factor in determining a company's sustainable growth rate and payout ratio, which can help investors make informed decisions.
Suggested literature
- Sasaki, H., & Fujita, S. (2012). The importance of the retention ratio in a Kaleckian model with debt accumulation. Metroeconomica, 63(3), 417-428.
- Gratchev, I., & Kim, D. H. (2016). On the reliability of the strength retention ratio for estimating the strength of weathered rocks. Engineering Geology, 201, 1-5.
