Retention Ratio

This is the opposite of the Dividend Payout Ratio. It is the ratio that represents the amount of profits retained by the business. It is sometimes referred to as retained earnings or ploughed back profits.

The formula is

Example

Think Tank co ltd financial statement at the end of the year showed net earnings of $100,000 in 2019. After paying cash dividends to the ordinary shareholders, the balance was $60,000

Required

i). Determine the retention ratio in 2019 (Hint-use both approaches)
ii). Interpret the results
 

SOLUTION

i)Retention Ratio in 2019

ii) Interpretation

For every one US Dollar net profit, 0.60 US Dollar is retained by the business.

Importance of Retention Ratio

1)    Available funds for re-investment by the business-the stakeholders are able to tell whether the management has plans to take advantage of profitable project opportunities when they arise
2)    Measure of possible conflict between the management and the shareholders-the higher the retention ratio, the lower the chances of the common stockholders will enjoy good returns from dividends and this may prompt to quarrel between the management and the owners of the business. 
3)    Measure of growth level of the business-the higher the retention ratio implies the firm is in the growth stage unlike where the retention ratio is low it implies the firm is in maturity stage and this information is important for managerial decision making purposes.
4)    Financing of the business-the higher the ration of retention is, the cheaper it is for a business to finance its projects other than using the costly sources of financing. Remember that according to pecking order theory by Myers and Majluf in 1984 argued that retained earnings is the cheapest source of financing.
 

Advantages of Retention Ratio 

1)    Increase owners wealth-retained profits results to increase in the capital base of the business in the long run and this means the owners original capital contribution monetary value has increased 
2)    Reduce debt/equity ratio- for highly geared firms, any retention of net earnings is a way of reducing the Debt/Equity ratio which threated a firm due to increasing chances of being put under liquidity by third parties such as debt lenders
3)    Increase external financing probability-when debt lender notice that the equity to debt ratio of a firm is low, it becomes easy and cheap to finance such a business unlike where the borrowing firm is having low retention ratio.
4)    High retention rate is stability assurance indicator-firms with high retention rate is an assurance of their future existence for they are financially sound
5)    Indicator of management efficiency in operations of the business-high retention ratio shows that the management is sound in its operations and decision making
 

Disadvantages of Retention Ratio 

1)    High retention ratio misinterpretation-high ratio does not mean proper management of the business for the issue of agency conflict cannot be washed away for sometimes retention ratio may be high and during actual investment, the wrong projects are identified to benefit the management at the expense of the shareholders
2)    High retention ratio scares away investors-anybody who invests in a business expects high returns and any retention ratio that is high means denying the investor such returns. Hence high retention firms are not popular amongst potential investors
3)    Failure to take advantage of tax shield benefits from external borrowing-maintaining high retention ratio means using more of retained earnings than external debts which have interest expense which is tax allowable.
4)    Low retention ratio for mature firms is dangerous-low retention means a big percentage is distributed to owners as dividends. This may imply that the management have not identified a business opportunity that can lead to expansion of the business such as diversification opportunity. Hence the business may crush and close down after maturity as usual if we go by the business cycle model.
 

Dividend Payout Ratio vs. Retention Ratio 

How are these two aspects related to one another? Table below portrays the difference between the two perspectives

Difference between Dividend Payout Ratio and Retention Ratio