Retained earnings is an integral concept to the theory of accounting and finance. They are part of the profits that a firm earns which, instead of being paid out as dividends to shareholders, it withholds or “retains.” These are usually sunk into the firm as investments or to pay debt or improve operational efficiency.
Retained earnings are the amount of net incomes the company has earned minus any dividends paid to the shareholders. Usually, such earnings go into re-investment in the company to finance business activities like acquiring new assets, R&D, paying off debt, or expanding operations. Retained earnings represent equity in the balance sheet of a company. They constitute the retained profit of a firm over time instead of being distributed to shareholders in the form of dividends.
Retained Earnings Formula:
Beginning Retained Earnings: The balance of retained earnings at the start of the period
Net Income: The income generated by the firm for the period (from operations).
Dividends Paid: Shareholders’ share of profit
Retained earnings is crucial as it acts as an excellent way for fueling the business, debt redemption, or as a cushioning device during the impending profits decrease in the future.
Importance of Retained Earnings
Retained earnings is essential for a firm and its shareholders as well. The following are a few points as to why they hold such significance:
1. Financing Growth and Expansion: A company’s retained earnings constitute a sizeable source of funding for its expansion endeavors. These can be used for capital expenditure or R&D, as well as other new ventures that include entry into new markets or introduction of new products. In most cases, it is cheaper to find this kind of money as compared to taking loans or offering new shares.
2. Building Financial Strength: Retained earnings add to the equity base of the firm, thereby strengthening the balance sheet. The stronger the retained earnings balance is, the better it acts as an economic buffer during times of slowdown or weak performance. It reduces the company’s dependency on external borrowing and helps the company hold on to its ability to command financial flexibility.
3. Enhancement of Shareholder Value: Although dividends offer a straightforward method for the company to compensate shareholders, retained earnings allow the firm to invest in projects that may eventually result in higher profits. This, in turn, may raise the price of the firm’s stocks, thereby improving shareholder value with time. Indeed, shareholders may even prefer profit to be retained for long-term capital appreciation rather than distributed to the shareholders as payments in dividends.
4. Debt Reduction: Retained earnings can also be utilized to settle company debt. An interest cost is reduced or, altogether, by paying down debt. Creditworthiness improves and resources are freed for further reinvestment in the business. This makes the company’s financial position stronger, making it more attractive to investors.
Formula for Retained Earnings:
Retained Earnings=Beginning Retained Earnings+Net Income−Dividends Paid
The calculation of retained earnings is quite simple because it is determined by a simple formula:
Let’s break down each component of the formula:
1. Beginning Retained Earnings: This is the retained earnings balance at the beginning of the period, often copied from the previous accounting period’s balance sheet.
2. Net Income: This is the profit, or loss for the period, for the company. It shows up on the income statement and represents the difference between a company’s revenues and expenses. When a company made a profit, this number will be positive, while a loss would result in a negative number.
3. Dividends Paid: This figure is presented as the dollar amount, percent of earnings paid to shareholders. If the company has declared dividends in the period, this dollar amount will be deducted from the net income in determining retained earnings.
Example Calculation:
You are given the following information about a company:
Beginning Retained Earnings – prior year: $500,000
Net Income for the year: $200,000
Dividends Paid: $50,000
Using the formula
Retained Earnings=500,000+200,000−50,000=650,000
Therefore, at the end of the year, the retained earnings of the company would be $650,000.
Determinants of Retained Earnings
Several determinants affect the retained earnings of a company. These, in turn, affect the amount of profit left as retained earnings or distributed. These determinants include:
1. Net Income or Loss
The most direct and straightforward impact on retained earnings is the net income of the company. Retained earnings will increase with a higher level of net income and reduce if the firm’s net result is a loss. Retained earnings balance becomes negative if a company has a loss, thus the term “accumulated deficit”.
2. Dividend Payout Policy
A company’s choice to pay dividends or to retain its profits greatly impacts retained earnings. Companies with a high dividend payout policy usually retain little because a bigger chunk of the profit goes into paying out the shareholders. Companies that pay out less or no dividends tend to retain a bigger chunk of their profits.
3. Business Investments and Growth Plans
Companies that intend to reinvest their profits into the business for growth, for example, by acquiring more assets or expanding capacity, are likely to retain most of their earnings. A high-level growth ambition business is likely to retain a greater proportion of its profits in order to fund expansion.
4. Tax Law or Regulation Changes
Taxation will affect retained earnings of a company. The higher the rate of a corporate tax rate, means that the company pays more of its taxes that reduce its net income, and accordingly, the retained earnings to be retained also decrease in amount. Another factor might be changes in tax authorities’ regulations on tax benefits or tax relief, with either positive or negative retention effects.
5. Debt Repayment
Companies can use retained earnings to retire outstanding debt. In reducing their debt burden, a company could have to apply part of its earnings to the debt, thus reducing its retained earnings. On the other hand, paying off debt may result in lower interest expense and better health in the long run.
6. Economic and Market Conditions
Macro factors like recession, inflation, or change in interest rate might affect a firm’s profitability. For instance, when the economy is in recession, a company’s revenues may go down and costs of operations increase; thus, its net income will be lower, meaning lower retained earnings.
Conclusion
The part and parcel of any company’s financial strength and growth plan is retained earnings. It is the retained portion of profits that a business retains in its own books instead of issuing it as dividends to the shareholders. Retained earnings play a very vital role in funding expansion, paying debts, and staying financially stable.
It is important then, that investors, analysts, and business owners understand retained earnings calculations, importance, and factors affecting them. They provide a window into the future about how well a company can grow sustainably, manage risks, and reward its shareholders in the long run.