What is the Plowback Ratio?
Plowback Ratio Definition
The plowback ratio is a financial metric that measures the percentage of earnings retained by a company for reinvestment back into the business.
It represents the portion of profits that aren’t paid out as dividends, and instead reinvested back into the organisation for future growth opportunities.
In other words, it is the amount of money “plowed back” into the business.
The plowback ratio is also known as the retention ratio or retention rate.
Plowback Ratio Formula
The plowback ratio formula is a simple one:
Plowback Ratio = [Retained Earnings / Net Income ] x 100
Where:
Retained Earnings = the portion of net income that a company chooses to keep, rather than pay to shareholders as dividends.
How to Calculate the Plowback Ratio
Calculating the plowback ratio is a relatively straightforward process of plugging the retained earnings and net income into the plowback ratio formula.
Let’s consider two example companies, A and B:
Company A
Net Income | £10m |
Dividends Paid | £2m |
Retained Earnings | £8m |
Company B
Net Income | £15m |
Dividends Paid | £10m |
Retained Earnings | £5m |
Company A has a plowback ratio of:
[£8m / £10m] × 100 = 80%
Company B has a plowback ratio of:
[£5m / £15m] × 100 = 33.33%
Therefore, we can determine that Company A has a higher plowback ratio than Company B, which indicates a greater commitment to reinvesting earnings for future growth compared to Company B.
Importance of the Plowback Ratio
Understanding and using the plowback ratio is important for a few key reasons:
Growth Indicator
A high plowback ratio suggests that a company is retaining a significant portion of its earnings for future growth initiatives.
On the other hand, a low ratio may suggest that the company is paying out a larger proportion of profits to shareholders as dividends, which will like limit any growth opportunities.
Reinvestment in the Business
Companies with a high plowback ratio often use retained earnings to fund research and development, purchase new assets, or take on projects to develop the business.
This reinvestment can lead to increased competitiveness, revenue and market share.
Impact on Shareholder Value
The plowback ratio is particularly important for shareholders.
A higher ratio implies that the company is reinvesting in growth, potentially leading to higher future earnings and, consequently, increased shareholder value.
Dividend Policy
Investors and analysts often consider the plowback ratio when evaluating a company’s dividend policy.
A low ratio may indicate a commitment to paying dividends, which can be appealing for shareholders looking for a stable income.