Retained Earnings are the accumulated portion of a company’s profits that are not released as dividends to shareholders and are instead set aside for reinvestment. These funds serve as the working capital of the business.
Because these earnings are not given to shareholders as dividends, they were kept or retained by the business. As a result, retained earnings are affected negatively when a company makes a loss, or pays dividends, but rise when profits increase.
These earnings are essentially revenue or profit that is “leftover”. They serve as a company’s reserve fund that may be used for several things, such as helping to grow the business, or repay debts. It can therefore be represented as a ratio or percentage of the business’s total revenue. This is referred to as the retention ratio.
At the end of every accounting period, retained earnings are recorded on the balance sheet under the shareholder’s equity section, and a report referred to as a statement of retained earnings is also kept, which shows how retained earnings have changed over time.
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Evaluating Retained Earnings
Retained Earnings (RE) are calculated by first adding the opening RE balance to the net income (or deducting a net loss), then subtract dividend payouts. The formula is as follows:
RE = Beginning Period RE + Net Income (or – net loss) – Stock Dividends – Cash Dividends
When evaluating RE, you need to take into consideration the following factors:
Whether the Industry Follows a Cyclical Pattern
When a company operates in a highly cyclical industry, it may be necessary for management to build up considerable retained profit reserves during the profitable phase of the cycle to protect the company during periods of economic decline.
The Company’s Age
An older business has had more time to accumulate greater retained earnings.
Its Policy Regarding Dividends
A corporation that pays out dividends regularly has less retained earnings.
The Profit Margin
A high-profit percentage ultimately produces a sizeable share of retained earnings.
What Is the Function of Retained Earnings?
Because retained earnings are recorded under shareholders’ equity, which connects the income statement and the balance sheet, they provide a valuable link between them. Retaining earnings can serve several functions, such as investing in research and development, purchasing new equipment and machinery, or other assets.
Retained earnings may also serve to launch new products or hire more sales staff to help drive profits. It may be helpful when used to engage in new partnerships, business acquisitions, and mergers.
The money may also be used to buy back shares or to repay the company’s debt. Debt repayment causes money to leave the company. However, it still has a positive influence on the accounts, as it saves future interest payments. This makes it eligible for inclusion in retained earnings.
The Components that Makeup Retained Earnings
Three components make up retained earnings, as we have seen in the formula above. They are:
- The beginning period RE
- Net income
- Cash or stock dividends
Beginning Period Retained Earnings
The term “beginning retained earnings” refers to the retained earnings from the previous year, which is used to determine the retained earnings for the current year. It is usually not included on a current balance sheet but is instead the prior year’s retained earnings.
A company’s retained earnings balance is not always a positive amount. This is because the current period’s net loss may exceed the RE beginning balance. A significant dividend distribution that exceeds the retained earnings balance, on the other hand, can also lead to a negative balance.
The Impact of Net Income on Retained Earnings
Retained earnings are based directly on net profit, so any changes to the net profit impact retained earnings. Increased or decreased net income, as well as the occurrence of a net loss, paves the way for either firm profitability or a deficit.
Due to huge, cumulative net losses, the retained earnings account could be negative. RE is affected by the same factors that affect net income. Sales income, depreciation, cost of goods sold, depreciation, and other operating expenses are examples of these factors.
Impairments or write-downs, which are non-cash items, and stock-related remuneration have an impact on retained earnings.
The Influence of Cash and Stock Dividends on RE
Dividends paid to shareholders are in the form of stock or cash. Both cash and stock dividends have a negative influence on the retained earnings of a business.
Instead of being reinvested in the business, a company’s profits may be distributed as cash dividends. Cash dividends are recorded as decreases in the financial account since they are a cash outflow. There is a resulting decrease in the company’s asset value because the corporation no longer controls a portion of its liquid assets.
Stock dividends involve issuing a company’s stock to its equity shareholders. When stock dividends are issued to shareholders, there is no outflow of cash. This allocation does not affect the company’s total balance sheet, but it does reduce the value of stocks per share.
Analyzing a Company’s Retained Earnings
Analysis of a company’s profitability is important to investors. However, the retained earnings in a given quarter or year may not provide useful information. Its analysis over a longer period (such as five years) only reveals a pattern in the amount of money a company adds to retained earnings.
It is helpful to calculate the company’s Retained Earnings to Market Value to determine the success of a business in utilizing its retained earnings. This value is calculated over several years and compares the change in stock prices to the company’s retained net earnings.
Low retained earnings to market value usually indicate a fragile or struggling business that has faced loss in previous years. High retained earnings to market value figures imply that a company has performed well over recent years.
Key Points
- The portion of a business’s revenue that remains after dividends are paid to shareholders is known as retained earnings.
- Retained earnings are the portion of a company’s net income that is not distributed to shareholders as dividends. Instead, it is reinvested into the business.
- Retained earnings drive revenue. They may be used for the purchase of assets, or to launch new products.
- The RE is influenced by the beginning period retained earnings, net income or loss, and cash or stock dividends.
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