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Retention ratio indicates the percentage of a company's earnings that are not paid out in dividends to shareholders but credited to retained earnings. It is the opposite of the dividend payout ratio, and is a key indicator of how much profit a company is keeping to fund its operations, growth, and development.
The retention ratio can be calculated using the following formula:
Retention Ratio = 1 − Dividend Payout Ratio = Retained Earnings / Net Income
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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A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-invested in the business. The current year profit as well as the retained earnings of previous years are available for distribution; a corporation is usually prohibited from paying a dividend out of its capital. Distribution to shareholders may be in cash or, if the corporation has a dividend reinvestment plan, the amount can be paid by the issue of further shares or by share repurchase. In some cases, the distribution may be of assets.
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