Retained earnings represent the profits remaining within a company after covering all expenses, taxes, and shareholder dividends. This signifies the share of the company's equity available for investment in areas like new equipment, research and development, and marketing.
A major part of fundamental analysis involves reading and understanding a company’s financial statements. This includes its profit and loss statement, balance sheet and cash flow statement. Among the many line items in these statements, you will find the retained earnings of a company, which are significant to various stakeholders like investors and the company’s management.
In this article, we take a closer look at what retained earnings are, the formula to calculate them and why they matter.
What is the meaning of retained earnings?
Retained earnings are the profits or the net earnings of a company that remain after dividends have been paid to shareholders. These profits are thus named because they are ‘retained’ or kept by the company. If a company does not pay dividends, any profits that remain after the entity has paid its taxes and other expenses are considered its retained earnings.
Understanding retained earnings in detail
The amount of a company’s revenue left over after its expenses are met makes up its profits. Different companies use these profits differently. Some companies, especially the ones focused on growth, may reinvest these profits back into the business. Others may pay dividends to their shareholders.
Even if a company that is well-established does decide to pay dividends, not all of its profits will be distributed to its shareholders. Only a part of the money will be paid as dividends. What remains is classified as the company’s retained earnings and is listed on its balance sheet under the shareholders’ equity section.
You can also study a company’s retained earnings statement to understand how they have changed over different years. An increase in the retained earnings means that the company is earning more profits and distributing less of it (and vice versa).
Example of retained earnings
Let us discuss a simple example of retained earnings and how they are calculated. Say a company earns a net revenue of Rs. 27 lakhs and pays dividends worth Rs. 5 lakhs to its shareholders. This means the company’s retained earnings for this financial year will amount to Rs. 22 lakhs (i.e. Rs. 27 lakhs — Rs. 5 lakhs). This will then be added to any retained earnings already available in the company’s books of accounts.
Formula of Retained earnings
Now that you know what retained earnings and where to find retained earnings on the balance sheet, let us discuss the formula and calculation involved. Here is how you can compute the earnings retained:
Retained earnings for a financial year = Net profit or loss during the FY + Retained earnings at the beginning of the FY — Dividends paid to shareholders
How to calculate retained earnings?
Let us discuss an example to understand this better. Consider the following parameters for a company.
- Retained earnings at the beginning of the year: Rs. 10,00,000
- Net income during the year: Rs. 6,25,000
- Dividends paid: Rs. 2,00,000
Using the formula given above, the retained earnings for the company are:
= Net profit or loss during the FY + Retained earnings at the beginning of the FY — Dividends paid to shareholders
= Rs. 6,25,000 + Rs. 10,00,000 — Rs. 2,00,000
= Rs. 14,25,000
How do companies use retained earnings?
Companies can use their retained earnings in different ways. Here are some common use cases for these retained profits.
- To fund regular business operations
- To innovate and develop new products and/or services
- To invest in future growth via business expansion
- To fund its marketing campaigns or purchase new equipment
- To ensure additional research and development
- To repay its debts and other liabilities
Significance of retained earnings
Retained earnings hold great significance for different stakeholders for various reasons. Here is why they are significant for investors, creditors and the company’s management.
- Investors: Retained earnings can be a sign of a company’s financial health and its potential growth in the future. Investors may consider retained earnings as a good sign because it indicates that the company is capable of funding its growth without borrowing money.
- Creditors: Creditors also care about the retained earnings of a company because it acts as a financial cushion. A company with sufficient earnings retained after dividend payments may be more capable of repaying its liabilities. This is a green flag for creditors like banks and other lenders.
- Management: Having a decent level of retained earnings also makes it easy for the company’s management to be more flexible in their decisions. They can finance new growth projects, improve existing products, innovate further and expand the business without having to borrow funds.
Effect of retained earnings on a company’s balance sheet
Retained earnings are typically classified as shareholders’ equity and are accordingly shown on a company’s balance sheet. An increase in a company’s retained earnings will have the effect of driving the owner’s equity upward. This is particularly true if the debts remain unchanged.
However, a decrease in retained earnings has the effect of reducing the overall shareholders’ equity shown on the company’s balance sheet. This may be because a larger portion of the company’s net revenue during the year is already paid out to the shareholders in the form of dividends or because the company’s net revenue has decreased.
Analysis of retained earnings
Analysing retained earnings can tell you a great deal about a company’s financial strength, its shareholders’ equity, dividend payout policies and revenue distribution pattern. More specifically, you can use financial ratios like the retention ratio to further analyse a company’s financial profile using its retained earnings.
Such analysis can be instrumental in making decisions about whether or not a stock could be a potentially good long-term investment. If you prefer an alternative or additional stream of income, you may want to choose stocks of companies that pay dividends frequently, even if it means lower retained earnings. However, if you prioritise capital growth, companies with high revenue and high retained earnings may be suitable.
Pros and cons of retained earnings
Retained earnings come with benefits and limitations for companies and investors. Here is a closer look at the pros and cons of this financial metric.
Retained earnings are useful because:
- They increase the value of a company’s stock
- They boost liquidity within the company as the entity has excess earnings
- They ensure the company has readily available funding for future growth
Retained earnings also have the following limitations:
- Shareholders may prefer dividend payouts
- Borrowing may be more effective than retaining earnings if the interest rates are low
How net income impacts retained earnings?
It must be understood that net Income, which is the profit after all expenses are deducted from total revenue, directly impacts retained earnings (RE). An increase in net income results in a higher RE balance, while a decrease or a net loss reduces RE.
Some common factors that influence net income are sales revenue, cost of goods sold (COGS), depreciation, and operating expenses. These factors also affect RE. For example,
- Higher sales revenue boosts net income and RE
- Whereas higher COGS and expenses reduce RE
Furthermore, non-cash items like write-downs, impairments, and stock-based compensation reduce net income and, consequently, RE, even without actual cash outflow.
How dividends impact retained earnings?
The distribution of dividends, whether in cash or stock, reduces retained earnings. Cash dividends involve a cash outflow, which lowers the company's cash balance and overall asset value. Also, cash dividends reduce the size of a company’s balance sheet.
On the other hand, stock dividends don't involve cash outflows; instead, they reallocate a portion of RE to the common stock and additional paid-in capital accounts. While this reallocation doesn’t change the total balance sheet size, it does reduce the value per share of the stocks. Therefore, it must be noted that any form of dividend distribution decreases the RE balance in a company.
Factors affecting retained earnings
Retained earnings reflect a company’s financial health. It is influenced by a variety of internal and external factors. Understanding these factors helps management, investors, and stakeholders evaluate the company’s financial performance and growth potential. For more clarity, let’s study some major factors that affect retained earnings of a company:
Business performance
How well the business performs is a major factor affecting retained earnings. Usually, a company can generate more profits and increase its retained earnings if it is:
- Profitable
- Growing its revenue
- Operating efficiently, and
- Managing costs effectively
Also, strong performance boosts sales, profit margins, and market share, which ultimately leads to higher retained earnings. On the other hand, poor performance, such as declining sales, reduced profit margins, or inefficient operations, limits retained earnings and raises concerns about the company’s financial health.
Investment decisions
It is worth mentioning that the strategic investment choices made by the company’s management significantly impact the level of retained earnings. Investments in growth areas like research and development, new equipment, acquisitions, or market expansion need significant financial resources.
When companies fund these initiatives using their profits, they reduce the amount of retained earnings available for distribution or re-investment. Also, investors should be aware of the fact that prudent investment decisions that yield good returns and create long-term value, increasing retained earnings. However, poor investment choices usually drain profits and decrease shareholder value.
Economic conditions
The overall economic environment, including factors like interest rates, inflation, exchange rates, and market stability, also impacts retained earnings. It has been commonly observed that economic downturns or recessions hurt a company’s:
- Revenue
- Profitability, and
- Cash flow
This negative impact reduces the current level of retained earnings as well as its pace of accumulation. Conversely, favourable economic conditions, such as strong economic growth, low unemployment, and stable markets, improve business performance and support the accumulation of retained earnings. Hence, companies must adapt their financial strategies and capital allocation to effectively handle changing economic conditions.
Conclusion
The retained earnings are only one of the many aspects you need to look into before investing in a company over the long term. You also need to study its profitability, analyse its financial ratios, find its valuation and then make an informed decision. An easier alternative is to choose equity which are managed by professional fund managers.
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