Chartered Financial Analyst (CFA) Level 1 Practice Exam

How is the retention rate calculated?

1. (Net income attributable to common shares - Common share dividends) / Net income attributable to common shares

2. Net income attributable to common shares / Total assets

3. Common share dividends / Total equity

4. Net income attributable to common shares / Common share dividends

The correct answer is: (Net income attributable to common shares - Common share dividends) / Net income attributable to common shares

The retention rate represents the proportion of earnings that a company retains for reinvestment in the business, rather than distributing as dividends to shareholders. It is calculated using the formula that focuses on net income attributable to common shares and the dividends paid to common shareholders. In this context, the correct formula is: (Net income attributable to common shares - Common share dividends) / Net income attributable to common shares. This calculation reflects the amount of net income that is not paid out as dividends, indicating how much profit is being retained for growth or reinvestment within the company. By dividing this retained income by the total net income, the retention rate highlights the share of earnings being reinvested, which is crucial for understanding a company’s growth strategy and financial health. Other options do not relate directly to the calculation of retention rate. For instance, net income attributable to common shares divided by total assets reflects return on assets, while common share dividends divided by total equity indicates the dividend payout ratio, neither of which captures the concept of retention effectively.