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The retention ratio, sometimes referred to as the plowback ratio, is the amount of retained earnings relative to earnings. Earnings can be referred to as net income and is found on the income statement. Retained earnings is shown in the numerator of the formula as net income minus dividends.
The retention ratio formula is an important component to other financial formulas, particularly growth formulas. The retention ratio formula looks at how much is kept by the company, as opposed to being paid out to common stock shareholders. Whatever amount the company retains, will be reinvested for growth in the company. A company's retained earnings could be considered an opportunity cost of paying dividends for stockholders to invest elsewhere.
A company that retains a large portion of its net income, will anticipate having high growth or opportunities to expand its business. High retention ratios are generally seen in growing companies more than established blue chip companies, but many other factors, such as the type of industry and stability of the overall economy, are considered as well.
The alternate formula to the retention ratio is 1 minus the payout ratio.
The payout ratio is the amount of dividends the company pays out divided by the net income. This formula can be rearranged to show that the retention ratio plus payout ratio equals 1, or essentially 100%. That is to say that the amount paid out in dividends plus the amount kept by the company comprises all of net income.
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