Limitations of the Retention Ratio

The retention ratio is the percentage of a company’s earnings that are not distributed as dividends. These earnings are credited to the retained earnings account. This figure is the opposite of the dividend payout ratio. The retention ratio also known as the retention rate, is the key factor for investors. But how can we tell if a company is paying out too much? Let’s examine the limitations of this measure. This article discusses some of the factors that should influence this measure.

Industry influences retention ratio

The industry in which a company operates can influence its retention ratio. If a company is in a mature industry, its retention ratio will be lower than that of a smaller, newly-invented firm. That’s because mature companies typically do not need to spend as much money on research and development. Instead, they are more likely to pay dividends to shareholders. Financial ratios such as retention ratios, however, have little meaning on their own. That’s why analysts look at them along with other financial metrics and compare them to other companies in the same industry to determine if a company’s retention rate is high or low.

The number of customers who remain with a company is crucial. In today’s world, a company’s customer retention ratio is critical for its continued growth and success. Industry-specific retention metrics are useful in determining which tactics are best suited to retain a customer base. The highest retention ratios are seen in the media, professional services, and retail. Lower retention rates are common in consumer services, hospitality, travel, and restaurants, which also experience the highest churn rates.

Limitations of retention ratio

One of the limitations of the retention ratio is that it cannot be used as a standalone measure of earnings performance. Its meaning varies based on the situation of a particular company. A manufacturing start-up may have a high retention ratio, whereas a service company may have a low one, and even a service company with a high retention rate could actually be paying out higher dividends. Companies that expect big losses should be more conservative with their retained earnings, but investors should still consider this in the context of their financial performance.

Another limitation of retention ratio is that it is only useful when comparing companies of similar size and stage. For example, an emerging company may have a low retention ratio because it lacks the cash flow that established firms enjoy. For this reason, a company’s retention ratio should be considered in conjunction with other ratios, such as its net profit, to see whether the numbers are indicative of a healthy company or not. However, one should not draw the wrong conclusion based on one single metric.