What is the Retention Ratio?

The retention ratio is the proportion of net income retained to fund the operational needs of a business. A high retention level indicates that management believes there are uses for the cash internally that provide a rate of return higher than the cost of capital. A low retention level means that most earnings are being shifted to investors in the form of dividends. The amount retained is known as retained earnings, which appears in the equity section of a firm’s balance sheet.

The ratio is used by growth investors to locate those companies that appear to be plowing money back into their operations, on the theory that this will result in an eventual increase in their stock price. This anticipatory use of the ratio may be incorrect in cases where company management anticipates a business downturn, and so retains extra funds simply to build a reserve against the leaner times that are expected in the near future.

A sudden reduction in the retention ratio can reflect a recognition by management that there are no further profitable investment opportunities for the business. If so, this can signal a major decline in the number of growth investors and a notable increase in the number of income investors who own the company's stock.

Related AccountingTools Courses

Business Ratios Guidebook

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How to Calculate the Retention Ratio

To calculate the retention ratio, subtract dividends paid from net income, and then divide by net income. The formula is as follows:

(Net income - Dividends paid) ÷ Net income = Retention ratio

Example of the Retention Ratio

ABC International reports net income of $100,000 and pays $30,000 of dividends. Its retention ratio is 70%, which is calculated as follows:

($100,000 Net income - $30,000 Dividends paid) ÷ $100,000 Net income = 70%

Problems with the Retention Ratio

There are several problems with the retention ratio, which are as follows:

Timing of the dividend payment. The board of directors may declare a dividend but not authorize payment until a period outside of when the retention ratio is being calculated, so no dividend subtraction appears in the numerator, even though it will take place at a later date. This can be a particular concern when the declared dividend is quite a large one in relation to the amount of net income generated, since it will trigger a sharp decline in the ratio in a later period.
Assumption that cash flow equals net income. There is an assumption built into the ratio that the amount of cash generated by a business matches its reported net income. This may not be the case, and especially under the accrual basis of accounting, where there can be a substantial divergence between the two numbers. When cash flows significantly differ from net income, the outcome of the retention ratio is highly suspect.

The Dividend Payout Ratio

The retention ratio is the inverse of the dividend payout ratio, which measures the proportion of net income paid out to investors as dividends or stock buybacks.