How Retention Ratios Indicate Company’s Health

Company’s financial health depends on various (both internal and external) factors.


Company’s financial health depends on various (both internal and external) factors. The present paper shared by examines the essence and economic meaning of the retention ratio. The principle of its calculation as well as further implications will be formulated. The relations between the dynamics of the company’s retention ratio and its plausible financial health will be clarified. In general, the retention ratio is a reliable indicator of company’s financial health, but it is also reasonable to use other indexes to make rational investment decisions.

First of all, it is necessary to provide the definition of the retention ratio. It refers to the fraction of the net income that is not paid out as dividends. Thus, it is the opposite financial indicator in comparison with the payout ratio that demonstrates the fraction of the net income that is paid out as dividends. Retention may be calculated in several ways. The first option refers to the calculation based on the definition of the retention ratio. In this case Retention Ratio = (Net Income – Dividends) / Net Income. The second calculation option refers to the modified first one: Retention Ratio = (1 – Dividends) / Net Income. The third option is based on the relationships between the retention ratio and the payout one: Retention Ratio = 1 – Payout Ratio. Finally, from the per-share perspective, it may be calculated as Retention Ratio = (1 – Dividends per Share) / EPS.

Thus, the growing fraction of dividends paid by the company corresponds to the declining retention ratio and vice versa. The retention ratio is maximized in the case the business entity does not pay any dividends (in this case, retention ratio = 100%). The retention ratio allows understanding company’s long-term business strategy. If its top management aims at the rapid market expansion, it is highly interested in increasing the level of investments. Therefore, the retention ratio will be lower than in those companies that do not aim to expand.

If the company’s management suggests that it is necessary to maximize short-term profits and competitive positions, then it will pay high dividends. Correspondingly, the retention ratio will be very low in this case. On the one hand, this strategy may lead to a higher demand for stocks among stockholders who are mostly interested in high dividends. On the other hand, it will not allow accumulating necessary reserves for financing large-scale investment projects and expanding company’s operations.

The level of the retention ratio may also depend on the industry of company’s operations. Very dynamic industries such as hi-tech or biotechnology ones may require higher investments and retention ratios from their companies. It is the only possible way of maintaining the consumer demand at an acceptable level, since these firms need to utilize the latest available technologies for meeting changing consumer preferences. Correspondingly, those companies that operate in more conservative and stable industries may have lower retention ratios. Therefore, when making the ultimate statement about their financial health, it is always important to compare their financial indicators with industry’s average figures. The deviation from the average ratio will allow understanding company’s strategy and financial health properly.

In general, systematically low retention ratios with other positive financial indicators demonstrate that company’s financial health is satisfactory. Moreover, such a company tries to become more innovative and implement additional investment projects. In order to make statements more precise, it is reasonable to assess characteristics of company’s investment projects. If they correspond to the major market trends, then it is very likely that the company will be able to increase its market share and strengthen its overall competitive positions.

However, in some cases, high retention rates can mean that the company has to respond to competitors’ pressure rather than implement independent investment projects. Moreover, retention rates per se outline only the general level of investments rather than their effectiveness. Therefore, companies with higher retention rates do not necessarily have a higher investment potential. At the same time, high retention rates are necessary for any successful growth model, especially if it is associated with proportional debt accumulation. In any case, it is reasonable to consider all relevant factors to assess company’s financial health correctly.

In general, the following steps should be made for using retention rates for evaluating the level of company’s financial health. Firstly, the current level of the retention ratio for a given company should be determined. Secondly, its dynamics should be assessed for understanding the existing tendencies. Thirdly, it should be compared with the industry’s average level. Finally, qualitative aspects of investments should be analyzed. If the company has the growing retention rates that exceed the industry’s average level and a qualitative assessment of its investments is positive, its financial health is satisfactory.

To summarize, the retention ratio is one of the most reliable indicators for evaluating company’s financial health. High retention ratios mean that the company invests the largest fraction of its net income in its further market development rather than pays it out as dividends. At the same time, it is necessary to assess the existing ratio dynamics and industry’s average figures. The character of company’s investments is also highly important since it affects its future competitive positions. After a thorough assessment of all above aspects, it is possible to make a correct conclusion about company’s financial health.