Wednesday, December 19, 2012

What Is a Retention Ratio?

Retention Ratio Definition

Retention Ratio refers to the percentage of a company's earnings that are not paid out in dividends but credited to retained earnings. It is the opposite of the dividend payout ratio. Retention ratio is also called plowback ratio or retention rate.


The Retention Ratio calculation formula is as following:
Retention Ratio = 1 - Dividend Payout Ratio = (Net Income - Dividends) / Net Income

Most often, retention ratio refers to the percentage of a company’s earnings that are not paid out as dividends to stockholders and are held back by the company. The earnings that are reinvested in the business are called retained earnings or retained capital. To calculate the earnings retention ratio, deduct the dividends from the company’s net income, and divide that total by the net income. The result is the retention ratio.

Investors are interested in learning a company’s retention ratio. A higher ratio means that more money is put back into the company. This can mean the company is poised for growth. Retained earnings can also be held back to pay for planned expenses, such as purchasing a building or new equipment. Since money is plowed back into the business, the retention ratio is sometimes called the plowback ratio.

Investors can use the retention ratio to calculate the maximum sustainable growth rate of a company. This growth rate is determined by multiplying the company’s return on equity by the retention ratio. The return on equity can usually be found in the company’s annual report. The maximum sustainable growth rate can be a factor when an investor decides whether or not to invest in a particular company.

A low retention ratio means that more money is paid out to stockholders. Investors looking for stocks to provide income generally look for companies with lower ratios. Companies with a history of such low numbers usually try to maintain these ratios, since investors come to expect dividends each year.

The term can also refer to a customer retention ratio or insurance retention ratio. Customer retention ratio is the percentage of customers that keep purchasing products and services from a particular company. A high figure can indicate quality goods or service. In other words, a high customer ratio equals satisfied customers.

Insurance retention ratio is the amount of business an insurance company retains. This is calculated based on premiums, or the amount each person pays for insurance coverage. Paid premiums represent sales. The insurance retention ratio is the percentage of invoiced, or written, premiums compared to the number of premiums that are actually paid, called gross premiums.

While retention ratio can refer to different numbers in various industries, it maintains a common theme. Retention refers to something a company keeps. Retention can refer to sales, customers, or earnings, depending on the context in which retention ratio is used.
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