In a balance sheet, along with share capital, another important written value is retained earnings. Share capital and retained earnings make up the total book value of the company.
These are the portion of profits that any company keeps within itself. The term Capitalization is important to understand, in financial terms, it means creating an asset or creating value out of an asset.
Any company’s income statement starts with the revenue or sales figure, deducting expenses, gross income, net income, taxes, dividends, retained earnings, and the last line is of net income.
When a company records profits, it pays out a portion of it to the shareholders in the dividend form or pays off debts.
Another important use of these profits is to keep a portion of it as retained earnings that become part of the total share capital of the company on the balance sheet.
Why do companies hold back part of profits?
What do they use it for?
There are many ways a company can use cash available with it, the prime focus of the company management is often on the achievement of the strategic objectives.
Retained earnings are held to create value and capitalize or maximize the gains for profit availability.
Research and Development:
One of the key factors for any company’s success is its research and development.
Any company needs continuous R&D focus to compete in the market.
Retained Earnings are often used for R&D purposes to launch new products or services.
Continuous improvements in operations and having a competitive edge in the market are the key factors for any company’s survival, which makes it the best use of retained earnings.
Investment in New Projects:
Similar to the R&D costs, another important internal use of the retained earnings is to arrange finance for projects with positive NPV.
Companies often need finances to invest in new projects; typically that financing comes from Either Equity or Debt.
Retained earnings are already part of the shareholders’ wealth, so utilizing retained earnings a wise method of reducing financing costs.
If a company has a long-term debt facility from the bank, the management may decide to reduce dividend payments and increase the retained earnings to pay off the debts.
Paying off debts with accumulated retained earnings can save companies a hefty interest cost.
Retained earnings are part of the Shareholders’ Equity, and the cost of equity is cheaper than the cost of debt, which also decreases the overall financing cost of capital (WACC) for the company.
DIVIDENDS AND RETAINED EARNINGS:
Once a company accumulates profits, it pays off its operating expenses and taxes.
The net profits are then utilized for two important factors for dividends and to retain the profits for company needs.
In a way, the dividend decision and retained earnings are correlated. Once the company pays out dividend, whatever left from it become retained earnings, on a flip side, the company may decide to increase the retained earnings and reduce the dividend payout amount.
For this correlation in larger companies, the retained earnings and dividends may have a large disparity between them over the years.
There is no binding obligation for any company to payout dividends, but retaining too much profit as retained earnings may also give bad signaling to the shareholders.
Retained earnings are accumulated over the years on the balance sheet and calculated as:
Beginning value of Retained Earnings + Net Income – Dividends = Ending Amount of Retained Earnings.
Using this simple formula, the statement of retained earnings is prepared. The retained earnings figures are important indicators for lenders and shareholders, as it provides an overview of the accumulated profits of the company.
In simple terms, retained earnings are part of the Shareholders’ Equity that a company holds in anticipation of future needs.
Once retained earnings are accumulated, they become part of the liability portion of the balance sheet that needs to be set off to the shareholders in the future.
As with any managerial or accounting indicators, the retained earnings figures and ratios should be interpreted carefully.
Negative retained earnings over the years may depict a company’s financial stress, but if the figures are from the current period the reader must pay attention to relevant causes.
Shareholders use Return on Equity (ROE) as an important indicator for performance measurement, and the decision on dividend payments and retained earnings can affect this important ratio.
However, the retained earnings as part of the total equity do not change the total book value of the company shares.