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Also known as a retention rate or earnings retention ratio, a plowback ratio is a type of measurement that focuses on the earnings that remain after dividends have been set aside for distribution to investors. Since the ratio is focused on what is left after dividends are paid, this helps companies to ascertain how much of those earnings can be invested or plowed back into growth projects related to the company. Business owners will look closely at this type of retention ratio as a means of gauging the success of the company’s revenue generation efforts as well as the effectiveness of efforts to reduce waste in the production process.
Company owners desire a higher plowback ratio for several reasons. One of the more important indications of a higher ratio is that the business is operating efficiently, with a minimum of waste in terms of the use of raw materials or the productivity of the workforce. At the same time, that higher ratio means that the company is able to retain more of the earnings generated by sales and various investments, effectively leaving more money to be allocated to growth projects such as the construction of new facilities or the launch of a new product. Since more money from earnings remains in the control of the company, there is less of a need to borrow in order to finance those endeavors, which in turn allows the business to expand without taking on additional debt.
The actual calculation of a plowback ratio involves identifying the amount of dividends paid on each share of stock as well as the amount of earnings generated per share. These figures are usually referred to as the dividend per equity share and the earnings per share respectively. To arrive at the plowback ratio, the dividend per equity share is divided by the earnings per share, with the result multiplied by 100 to determine the payout ratio for the period under consideration. The payout ration is then subtracted from 100, with the plowback ratio being the result.
A lower plowback ratio does not necessarily mean the company is in financial trouble. The figure may indicate that a larger portion of the revenue generated is going to pay dividends to investors, a situation that may be fine if the company prefers to grow at a slower pace. When the goals of the business have to do with rapid expansion, that lower ratio may mean that changes must be made in order to increase the amount of revenue that is retained after honoring commitments to investors, either by increasing sales or lowering operational expenses. In any event, determining the plowback ratio provides a sense of how well the business is doing in terms of retaining sufficient earnings to increase the financial stability of the business or to generate resources that will come in handy with expansion efforts.
I don't understand what the "waste in terms of the use of raw materials or the productivity of the workforce" has to do with the plowback. Can you explain better? --Miguel C.