Retained earnings are profits or earnings of the business that have been kept for business use and not distributed to the owners or stockholders. In other words, retained earnings are accumulated earnings of a business after paying dividends or drawings to its stockholders or owners.
Retained earnings can also be accumulated losses of the business if the business has made more losses and paid more dividends than it has made profits.
All of a business’ earnings are not distributed to the owners of the business because funds are needed in day to day operations of a business. Usually businesses pay a percentage of the earnings of the business, for that financial year, to its owners.
However, businesses may choose not to pay any portion of the earnings to the owners in case the business needs the earnings for some future operation.
The percentage of retained earnings and dividends vary from business to business. This percentage is very low for services-based businesses as the owners will draw a major part of the earnings for the year.
Services-based businesses don’t keep a high retention ratio because these businesses don’t need to reinvest in major projects such as fixed assets. In contrast, manufacturing-based businesses will keep a higher percentage of retained earnings because more funds are needed in the business.
Businesses want the maximum amount of earnings to be retained in case of future needs for finance. Owners, on the contrary, want the maximum amount of dividends to increase their returns on the investment.
Businesses have to reach an ideal point where both the needs of the business and its owners are satisfied. The decision regarding the percentage is made by the management of the business but can still be challenged by the owners.
For companies, contrary to popular belief, if a company chooses not to pay dividends and retain all its earnings, it still generates wealth for its stockholders.
This wealth, however, is not generated in form of dividends but in form of an appreciation in the value of the stockholders’ stocks. Companies like Microsoft and Amazon seldom pay dividends and generate wealth for investors in the form of stock appreciation.
Retained Earnings: Advantages and Disadvantages
There are several advantages and disadvantages of retained earnings for a business.
- Retained earnings enhance the financial position of a business. This further helps the business to attract equity and debt finance investors. For example, a business with a strong financial position can easily obtain a loan from the bank as compared to a business with a weak financial position.
- Retained earnings can be used as a reserve in times of a downturn in the business. A company, for example, can use retained earnings to run its daily operations when it can’t generate earnings. Furthermore, retained earnings can be used to pay dividends to the stockholders of the company even if the company makes a loss for a year.
- Retained earnings can help increase the net worth of a business. For example, if a company chooses to retain earnings, as mentioned before, the market value of the stock of the company will appreciate in value.
- Finally, retained earnings are a cheaper alternative to other sources of finance for a company because it is internally generated. When a business raises equity or debt finance, it has to bear certain costs, which is not the case with retained earnings. Furthermore, businesses don’t need to meet any credit rating or security requirements to use retained earnings, unlike debt finance.
- Businesses that do not have a specific purpose for retained earnings end up not utilizing the retained earnings. A business should have a proper plan for the retained earnings or else consider paying higher dividends to its owners.
- A business may choose to retain all its earnings without paying dividends to investors and opt to generate wealth for owners through market value appreciation of their holding. Under some tax jurisdictions, dividends are not taxable or are taxed at a lower rate as compared to capital gains. This can be disadvantageous for the owners of the business and the management of the business may face a backlash from its owners.
Retained Earnings: Formula and Calculation
The retained earnings of a business at the end of a specific period can be calculated as follows:
Retained Earnings = Accumulated Retained Earnings Last Year + Net Income for Current Year – Net Loss for Current Year – Dividends/Drawings Paid to Owners
The figures in the formula are very easy to obtain from a business’ Financial Statements. The Accumulated Retained Earnings for last year can be obtained from the balance sheet of a business for the last year.
The Net Income or Net Loss of a business for the year can be found from its income statement. Finally, the dividends or drawings paid to owners can also be found in either the balance sheet or the statement of retained earnings of a business.
For example, a company ABC Co. had retained earnings of $25 million at the end of 2018 and generated earnings of $7.5 million in 2019.
The company paid $2.5 million in dividends to its stockholders for the year. Its retained earnings at the end of 2019 will be $30 million ($25 million + $7.5 million earnings – 2.5 million dividends paid).
Statement of Retained Earnings
The statement of retained earnings also known as the statement of (changes in/owner’s) equity is a dedicated financial statement to track changes in the retained earnings of a business over time.
The statement shows how the business’ retained earnings have changed over time using the formula above. The statement begins with a beginning balance of retained earnings (previous year’s), then adds the net earnings for that year to it or subtracts the net loss of that year from it and finally, subtracts the number of dividends paid or drawings made by owners of the business for the year.
Businesses use it to allow their owners to know about the changes in the retained earnings of the business. Owners use it to understand how their equity has changed over time.
Finally, potential investors use it to estimate the value of their investment through the changes in the retained earnings.
Investors can determine the percentage of retained earnings or dividends from the statement and use it to make decisions about investing in the business.
Retained earnings are a great source of finance for a business and can be used to finance different projects. Different businesses can have different percentages of retained earnings according to their needs.
Potential investors also consider the retained earnings history of a company to determine the value of their investment. They can use the statement of retained earnings to get this information easily.