Retention Ratio Calculator
We have prepared the retention ratio calculator to help you to calculate the retention ratio of a public company. The retention ratio calculation is important in analysing a company's reinvestment policy. The metric is also crucial in estimating the growth of a company.
We have written this article to help you understand what a retention ratio is and how to calculate it using the retention ratio formula. We will also demonstrate some examples to help you understand the concept. Now, let's start by understanding the retention ratio definition.
What is the retention ratio?
The retention ratio definition is the ratio of the retained earnings to the net profit of a company. As retained earnings is the profit remaining after the dividends are distributed to the common shareholders from the net profit, the retention ratio measures the portion of net profit that is being reinvested into the business.
It is crucial to understand the retention ratio formula as the reinvestment policy of a company significantly impacts its growth prospect. In general, the more money you reinvest, the faster the company will grow. However, this is not always the case. Since every company has different characteristics and face various industry dynamics, every company has a different optimal retention ratio. Sometimes, it can hurt a company's value by over-reinvesting.
Now that we have understood the retention ratio definition, let's dive into analyzing the retention ratio formula.
How to calculate retention ratio?
Let's take the company below as an example to demonstrate how our retention ratio calculator works:
- Name: Company Alpha
- Net income: $1,000,000
- Dividends paid: $350,000
The retention ratio formula is very simple and straightforward. There are only two steps involved:
- Calculate the retained earnings
retained earningsis the money remaining in the business after the dividends are distributed to the common shareholders. It also represents the money being reinvested into the business.
We can calculate
retained earningsas follows:
retained earnings = net income - dividends paid
For Company Alpha, the
retained earningsis equal to
$1,000,000 - $350,000 = $650,000.
- Calculate the retention ratio
We are now ready to calculate the
retention ratio. We can do this using the equation below:
retention ratio = retained earnings / net income
retained earningsof Company Alpha is
$650,000 / $1,000,000 = 65%.
You can obtain the same result much quicker with the retention ratio calculator.
The retention ratio calculator: results interpretation
It is essential to understand the company and the industry before you try to figure out the retention ratio meaning. This is because different companies have different optimal ranges for their retention ratios.
For instance, a high-growth technology company will have a high retention ratio. Investors are willing to forgo their dividends as they believe the company should reinvest its earnings as there are still a lot of profitable growth opportunities for the company.
On the other hand, investors of a mature blue-chip company might demand the dividends to be distributed. This is because they believe the growth of the company is limited and it is better to distribute the dividends than to reinvest the money into a projects within the company of minimal impact.
Hence, before you come to a conclusion, make sure you understand the company and the industry you are analyzing. The retention ratio meaning might be different in different environments.
What is a dividend?
Dividends are the money that public listed companies distribute to their investors. This normally happens quarterly or semi-annually. This is a way of distributing the value generated by the business back to its investors.
What is net income?
Net income is also called net profit. It is the bottom line of a company's operation. It is the accounting money that the company earns after deducting all the necessary operational, financing, and tax expenses.
What is a good retention ratio?
Different companies have different optimal retention ratios. For a high-growth company, it makes sense to have a high retention ratio as there are a lot of profitable growth opportunities for the business. However, a mature company might have a low retention ratio as it is better for them to distribute dividends to its investors instead of reinvesting them into the business.
Can retention ratio be negative?
Yes, it is possible for a company to have a negative retention ratio. However, this will mean that the company is lending money to distribute its dividends. Hence, it is reasonable to believe that the dividend might be canceled in the future.
What is the limitation of the retention ratio?
Even though the retention ratio can tell you how much earnings are being reinvested into the business, it does not tell you how the money is being used. It also does not tell you the results and performance of the reinvestments.