Retention ratio = (Net income – dividends) ÷ Net income
Retention ratio is also known as plowback ratio and it helps an investor, economist or financial analyst to find the percentage of earnings a company is holding for future growth. In this formula the net income is available at the income statement of a company. While calculations for retained earnings is carried out in the numerator when you subtract net income and dividends.
Retention ratio is considered as an important part of evaluation techniques where investor is looking into the growth perspective of a company along with other financial ratios. As we said earlier retention ratio basically focuses on the decision of company for amount kept as opposed to amount paid as dividend with a vision of future growth and investment. Financial analysts considers retained earnings as an opportunity cost of paying dividends for stockholders rather than to invest anywhere else.
Companies which have a higher retention ratio are typically considered as high growth opportunity investment in future. However, this doesn’t happens all the time as many external factors also influence the growth including economic conditions, stability of industry, market segments, competitors and more.
Alternatives to retention ratio formula
We can use dividend payout ratio as an alternative to retention ratio. We can subtract 1 from payout ratio the expression in result will be the retention ratio alternative.
Retention ratio = 1 – Payout ratio
Dividend Payout ratio is calculated by dividing total dividend paid by net income of the company. One can rearrange the equation to figure out the retention ratio plus payout ratio which is equal to 1 or 100%. When we move retention ratio to one side, the payout ratio goes to the other side with a negative sign with it.