Retained Earnings

Retained earnings are a firm's cumulative net earnings or profit after accounting for dividends.
Retained Earnings
3 min
06-June-2024<br><br>

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

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 mutual funds, which are managed by professional fund managers.

On the Bajaj Finserv Mutual Fund Platform, you can find more than 1,000 mutual fund schemes that are easy to invest in. You can compare these mutual funds, analyse the assets they invest in and make an informed investment decision. What’s more, you can even choose between a lumpsum investment or a SIP Investment strategy — whichever is convenient for you.

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Frequently asked questions

How are the retained earnings of a company different from dividends?
Dividends are a part of the company’s profits paid out to shareholders. Retained earnings are the profits that remain after dividend payouts.
How are retained earnings different from revenue?
The revenue of a company is the net income earned during the year. Retained earnings, however, are the profits that remain after the dividend is paid.
What are the downsides of retained earnings?
Excessive retained earnings may indicate significant amounts of undistributed profits. This may lead to shareholder dissatisfaction. Also, since profits change from one year to the next, retained earnings are not a reliable source of funding.
Are retained earnings a part of a company’s equity?
Yes, retained earnings are considered to be a part of shareholders’ equity. You can find the retained earnings on the balance sheet’s equity side.
Are retained earnings considered current liabilities?
No, retained earnings are not classified as current liabilities. However, they are listed in the liabilities side of the balance sheet, in the equity section.
Where are retained earnings presented in a balance sheet?
The retained earnings are presented under the shareholders’ equity section of the balance sheet because they represent a company’s undistributed profits.
Are retained earnings the same as a company’s profits?
Retained earnings are a part of a company’s profits. They refer to the portion of the profits that remains after a company pays dividends to its shareholders.
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Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.