What is Retention Ratio
Retention ratio is a financial ratio that measures the percentage that the company uses its net income to reinvest into the company instead of paying out to shareholders as dividends. A retention ratio reflects the portion that the company uses its income to reinvest to expand the operation activity compared with the net income.
A higher retention ratio indicates the company reinvests a larger amount by using its net income. Conversely, a lower retention ratio indicates that the company pays out the dividends to shareholders rather than reinvests (reinvest with a lower amount).
However, there is no exact good or bad retention ratio that can indicate the good or bad financial health of the company. This is because it really depends on the company’s dividend policy and strategy.
Retention Ratio Formula
The retention ratio can be calculated by dividing the company’s net income after paying out the dividend by the net income as the following retention ratio formula:
Retention Ratio = (Net Income – Dividends) / Net Income
or using the earnings per share (EPS) and dividend per share (DPS) as the following formula:
Retention Ratio = (EPS – DPS) / EPS
For example, the Feriors company limited has a net income of $400,000 and pay out the dividends of $10,000 in the last financial year. The retention ratio will be: Retention ratio = (400,000 – 10,000) / 400,000 = 0.975 or 97.5%
This means the Feriors company reinvest 97.5% of its income last year.
Frequently Asked Questions
A retention ratio is a financial ratio that measures the percentage that the company uses its net income to reinvest into the company instead of paying out to shareholders as dividends.
The retention ratio can be calculated by dividing the company’s net income after paying out the dividend by the net income as the following formula: Retention Ratio = (Net Income – Dividends) / Net Income
