The retention ratio, also called the plowback ratio, is the share of a company's profit that it keeps and reinvests in the business instead of paying out as dividends. The formula is retained earnings for the year divided by net income, which is the same as 1 minus the payout ratio. If a company pays out 40% of its profit as dividends, it retains the other 60%. The kept money funds new equipment, research, acquisitions or debt repayment, and it is the fuel for the company's growth without borrowing or issuing new shares.
Worked example
Company A earns $10 million in a year and pays $4 million of it as dividends. Payout ratio = $4 million ÷ $10 million = 40%. Retention ratio = 1 minus 0.40 = 60%, which is $6 million kept in the business. Now say Company A earns 15% a year on its shareholders' equity (its return on equity). Sustainable growth rate = return on equity × retention ratio = 15% × 0.60 = 9%. That is roughly how fast the company could grow its profit from its own money alone, if its return on equity stays the same.
Why it matters
The retention ratio shows how a company splits its profit between paying shareholders now and funding growth later. You find the dividend and net income in the income statement and cash flow statement of the annual report. A high ratio is not good or bad on its own: a young growth company may keep nearly everything because it has projects worth funding, while a mature one with few projects may pay most of it out. What matters is what the company earns on the money it keeps. Retained profit that earns a poor return does little for shareholders. So a high or low retention ratio is a question to look into, not a verdict: check it next to the return on equity, and compare with companies in the same industry and with the company's own earlier years.
Frequently asked questions
The plowback ratio is another name for the retention ratio: the share of net income a company keeps in the business instead of paying as dividends. It equals retained earnings divided by net income, or 1 minus the payout ratio.
Divide the profit kept in the business by net income, or take 1 minus the payout ratio. If a company earns $10 million and pays $4 million in dividends, it keeps $6 million, so the retention ratio is 60%.
Multiply the retention ratio by the return on equity to get the sustainable growth rate, the pace a company could grow from its own profit without new debt or shares. It holds only while the return on equity stays the same.
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