What is Retention Ratio? Definition, Formula and Limitations

It is a common practice for companies to pay dividends to its shareholders out of the profits earned. Normally, dividends are paid quarterly, which is also referred to as interim dividends. The company, however, does not pay out the entire profits as dividends, but retains part of the profits as an investment for the future. Using a SIP Calculator can help investors plan their systematic investments and maximize returns by understanding the power of disciplined investing.

The part of profits not paid out as dividend is the Retention. The relationship between profits made by the company and retained after the dividends is shown by the dividend retention ratio. In this blog you will learn more about this important ratio which you can then use for your own analysis of stocks.

Retention Ratio Meaning in Finance?

Let us say that a company earns a profit of ₹10 crore and pays out ₹4 crore as dividends to its shareholders. In this case, the dividend payout ratio would be 40% (4/10). The balance amount that is retained in the company i.e., 60% (6/10) is the retention ratio.

The retention ratio is the extent of profits not paid out as dividends to shareholders but retained within the company for future investments. Generally, companies that have future investment plans tend to have a higher retention ratio while companies that are generating a lot of cash but do not have future growth plans, have higher dividend payout ratios.

How to Calculate Retention Ratio and Retained Earnings Using a Formula?

The retained earnings is the portion of earnings that is retained in the company after dividends are paid out. Typically, once the company reports the profits after tax, then we come to post-tax appropriations. Firstly, you pay the dividends to preference shareholders and after that dividends are paid to equity shareholders. Hence we can write the formula for retention ratio as under.

Retention = Net Profits – Dividends to Preference Shareholders – Dividends to equity shareholders

You can also represent the retention ratio formula in the form of a ratio as under.

Retention Ratio = Retention (as shown above) / Net Profits of the company

Example of Retention Ratio in Practice

Let us understand retention ratio meaning with a live example. Assume that a Company X, based out of Gurugram, and into the auto ancillaries business, has earned net profits of ₹27 crore for the financial year FY24. During the year, the company paid ₹2 crore as dividends to preference shareholders and also paid ₹Rs7 crore as dividends to equity shareholders. In this case, the formula for retention ratio can be expressed as under.

Retention = Net Profit – Preference Dividend – Equity Dividend

This formula for retention ratio can be rewritten as:

Retention = ₹27 crore – ₹2 crore – ₹7 crore = ₹18 crore

The formula for retention ratio in this case can be written as:

Retention Ratio = Retention / Net Profits

Hence, Retention Ratio = ₹18 crore / ₹27 crore = 66.7%

While the Retention and the Retention Ratio can be calculated from the overall figures, they can also be calculated from the per share figures. Assuming the company has 1 crore shares as outstanding issued capital, the EPS would be ₹27 and DPS will be ₹7. Here let us assume for simplicity that there is no preference dividend.

Hence Retention ratio will be (27 – 7) / 27 = 74.1%

However, if there are preference dividends also payable, then it is best to calculate retention and retention ratio based on total net profits and total dividends paid out.

Significance of Retention Ratio

The retention ratio is a very important signal by the company to the shareholders and to the stock markets about the future investment plans of the company. The dividend payout shows that the company wants to reward shareholders and that the company has cash. However, it is the retention ratio that makes a statement about the future investment and growth prospects of the company.

The retention ratio also has a strong significance from the point of view of the valuation of the company. Generally, the paradigm has been that companies that pay out more as dividend get a lower valuation compared to companies that retain more of their earnings for future investments. This is subject to one condition that the company has a high ROE. For instance, a company with a 70% retention ratio and return on equity (ROE) of 25%, will automatically get a good valuation as the retention is happening at a much higher internal return.

Limitations of Using the Retention Ratio

The retention ratio has a number of pitfalls too. For instance, it only talks about the amount of profits that is retained internally, but speaks little about the usage of the funds. Secondly, the retention ratio by itself does not tell you much about the profitability of the company and hence it will have to be compared to the peer group.

There are some industry level eccentricities in the retention ratio. For instance, sectors like metals and utilities tend to have low retention ratios while IT and telecom tend to have higher retention ratios. Hence comparison across industries is not feasible. The retention ratio can also be manipulated to appeal to the market, but may not give the right picture.

Factors Influencing Retention Ratio

The key factors that influence the retention ratio are as follows:

• The ratio is very industry centric. Some industries like utilities and metals have low retention ratios. Similarly, companies like FMCG and some of the MNC companies pay out high rupee dividends.
• Retention also depends on growth opportunities. Companies with growth prospects tend to have more retention while the cash cows that do not need future outlays will have lower retention.
• Normally, large companies in India have stable dividend payout policies and they do not vary this figure on a yearly basis. They operate on a target dividend pay ratio. This tends to keep the retention ratio stable for large companies.
• Volatile earnings normally tends to make companies more cautious and such companies may prefer to retain more profits in the company, rather than payout dividends.

Conclusion

To sum up, retention ratio is a statement of intent of any company. Normally, companies with future growth prospects and investment opportunities tend to have a higher retention ratio. Companies with limited opportunities and generating a lot of cash tend to pay out more as dividends. One point to remember is that the dividend payout ratio and the retention ratio must be looked at in terms of sustainable dividends paid.

Hence any special dividend or one-time dividend paid out of special profits should be excluded from this calculation. But, the retention ratio has a lot of value in understanding how the stock markets value companies. Companies with high retention ratios and also high ROE tend to get rewarded by the stock markets with higher valuation ratios.