A retention ratio could be the proportion of net gain retained to fund the operational needs of a business. When there exists a high retention degree, it typically ensures that management believes you will discover uses for money internally that will supply a rate of return higher than the cost of capital. Anyway, if management is retaining funds for which there isn’t a good utilize, investors may finish up earning a negative return on the funds.
The ratio is needed by growth investors to uncover those companies that look like plowing money on their operations, on the theory that this will result in an increase into their stock price. This anticipatory by using the ratio could possibly be incorrect in situations where company management anticipates an enterprise downturn, and elects to be able to retain extra funds merely to build a reserve from the leaner times that are expected soon.
An abrupt reduction in the actual retention ratio can reflect a acknowledgement by management that have no further rewarding investment opportunities with the business. If and so, this can signal an essential decline in the number of growth investors and also a notable increase in the number of income investors who own their stock.
The retention ratio formula is:
(Net income – Dividends paid) / Net income
For example, 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%
A problem with this formula is the timing on the dividend payment. The board involving directors may announce a dividend and not authorize payment until a moment outside of if the retention ratio is being calculated, so no dividend subtraction appears from the numerator.
Another difficulty with the ratio is the underlying conjecture that the amount of cash generated by a business matches its reported net income. This may not be the case, and particularly under the growth basis of accounting, where there can be a extensive divergence between the two numbers. When cash flows considerably differ from net income, the outcome of the retention ratio is greatly suspect.
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.