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Friday, June 21, 2024

What are retained earnings?

What are retained earnings?

05.17.2024

Introduction to retained earnings

Retained earnings are the portion of profits that a company maintains rather than paying out to shareholders as dividends. The greater the portion of profit that a company pays out as dividends, the lower its retained earnings will be, and vice versa.

Rather than paying these earnings out as dividends, companies keep them to reinvest in the business. They may be used to pay off debt, make capital expenditures, or make investments necessary to expand the business.

Retained earnings are an important part of business operations, especially for companies in the growth phase. They appear on the company’s balance sheet and may factor into its valuation.

Importance of retained earnings

Retained earnings are important for both the business and its investors, and they can be beneficial for both parties. They’re indicative of a company’s financial health and its ability to reinvest in growth opportunities.

Significance for the business

Retained earnings are a way for a company to invest in business growth. They allow a company to do a variety of things, including:

  • Fund its business operations
  • Purchase new property or equipment
  • Pay off debt
  • Invest in research and development
  • Expand business operations
  • Build cash reserves
  • Merge with or acquire another company
  • Stock buybacks

It’s the company’s management that determines how much of its profit it should retain, as well as what to do with those retained earnings.

Certain types of companies may be more likely to have high retained earnings.  For example, retained earnings are particularly important for young companies and those in the growth phase. Those companies might not pay any dividends at all and instead retain all of their profits to invest in the company’s growth.

On the other hand, an older, more established company may have less need to invest in growth and, therefore, may be more likely to pay out a larger portion of its profits as dividends. Growing companies, on the other hand, might not pay any dividends at all and instead retain all of their profits to invest in the company’s growth.

Another type of company that may be more likely to have high retained earnings is a seasonal company. Seasonal companies — think road construction companies or ski resorts — may earn most of their profits during a particular time of year and have lower earnings the rest of the year. They may be more likely to have high retained earnings to help them cover business expenses in their off-seasons.

Finally, private companies may have higher retained earnings than publicly traded ones. Public companies have investors they want to attract and retain, and so they may prioritize dividends. A private company without shareholders to consider may be more likely to maintain its earnings.

Significance for investors

Retained earnings are just as important for investors as they are for businesses. At first glance, it might seem like investors would frown upon retained earnings because it means a company isn’t paying out its profits in the form of dividends. In reality, retained earnings can help a company attract more investors.

First, a strong retained earnings history suggests a financially sound business. Many investors — especially long-term investors — want to invest in companies with longevity and stability. Many years of solid retained earnings can indicate just that.

Retained earnings may also suggest a company is more prepared to weather financial storms such as economic downturns. Just as an emergency fund is an important financial safety net for individuals, retained earnings can be an important safety net for companies.

Though retained earnings are important for investors, they certainly aren’t the only factor to consider. If you’re looking at a company’s balance sheet to decide whether to invest, consider retained earnings alongside other figures.

Are retained earnings an asset?

Retained earnings may seem like they would be an asset since they are the cash the company has on hand. However, technically speaking, they aren’t considered an asset.

Retained earnings appear on a company’s balance sheet. But instead of appearing as an asset, they appear as stockholders’ equity (also known as shareholders’ equity). Rather than thinking of retained earnings as an asset, think of them as money that belongs to the shareholders but is currently residing in the business.

Retained earnings, along with the other figures that make up shareholder equity, represent the difference between a company’s assets and liabilities and help determine both its value and the amount that would be paid out to investors if the company was liquidated.

Utilization of retained earnings

Companies can use retained earnings in a variety of ways. First, companies can use retained earnings to make large investments in the business. They may do this by purchasing new property or equipment, investing in research and development, growing their inventory, or hiring additional staff.

Next, companies may use their retained earnings to make major business moves, including merging with or acquiring new businesses or buying back company stock.

Finally, a company could use retained earnings to help build a financial safety net. For example, it might use the money to pay off debt or set it aside in a rainy-day fund to help weather financial storms or market downturns.

What a company uses its retained earnings for is likely to depend on the phase of business growth it's in. A well-established company is likely to use its retained earnings differently than a newer company that’s growing rapidly. The amount of retained earnings a company has and what it uses them for can tell you a lot about both a company’s health and its priorities.

Statement of retained earnings

A company’s retained earnings appear on what’s called a statement of retained earnings. It’s a lesser-known financial statement that a company prepares along with its income statement, balance sheet, and cash flow statement.

A statement of retained earnings is prepared at the end of each reporting period and lists a company’s retained earnings and how that number changed from previous reporting periods. It generally includes the following information:

  • Beginning retained earnings
  • Net income
  • Dividends
  • Ending retained earnings

The statement of retained earnings can be helpful for both internal and external use. The company might use this statement to strategize for the next reporting period and determine whether it wants to make any changes. Meanwhile, a shareholder or potential investor might use the retained earnings statement to assess a company’s financial health.

Retained earnings formula

Retained earnings are calculated by adding the beginning net earnings and net income and then subtracting dividends paid. The formula looks like this:

Retained Earnings = Beginning Retained Earnings + Net Income (or Loss) - Dividends

Calculating your total retained earnings starts with the amount of retained earnings on hand at the beginning of the reporting period. This is an important starting point since it helps us to see whether a company had positive or negative retained earnings during the reporting period.

Next, you’ll add the company’s net income or losses to the beginning retained earnings. Net income is calculated by subtracting business expenses from net income. Ideally, this number would be positive. However, if a company is experiencing a down period, it could have a net loss.

Next, you’ll subtract dividend payments from the sum of the beginning retained earnings and the net income. This figure should include cash dividends for both common and preferred stockholders, as well as stock dividends.

Read more: How to calculate dividends

The resulting figure is your ending retained earnings formula, which will also be your beginning retained earnings figure for the next reporting period. Positive retained earnings are a good thing — it indicates a company is financially healthy.

Meanwhile, negative retained earnings can be a red flag. It means that a company’s dividend payments may have exceeded its net income and indicates the company may not be financially healthy.

Understanding retained earnings ratio

Financial ratios are one of the primary ways that investors and analysts evaluate companies. Retained earnings is one of the many different ratios that investors can use to evaluate a business’s health. Ideally, a company’s total retained earnings would remain stable and increase over time. On the other hand, seeing the retained earnings decrease over time — or even become negative — is problematic.

There’s not necessarily one correct retained earnings ratio that all companies should strive for. Instead, the optimal figure for each company is based on its financial circumstances and goals. A larger, more well-established company may aim to have a lower retained earnings ratio since it pays out more of its profits to shareholders in the form of dividends. On the other hand, a company that’s growing quickly is likely to have a higher retained earnings ratio.

As a general rule, the ideal retained earnings to assets ratio is 1:1, meaning a company should strive to have an amount of retained earnings that’s equal to its total assets. That being said, because each company is different, most businesses won’t have that exact ratio.

Finally, though the retained earnings ratio is important, it’s not the single most important financial ratio. If you’re assessing a company to decide whether to invest in it, you’re likely to pay more attention to ratios such as earnings per share, price-to-earnings ratio, return on equity, and more.

Understanding retained earnings vs. revenue

Retained earnings and revenue are two critical figures in a company’s financial makeup. A company’s revenue represents the total income generated from the sale of goods and services. For example, if you’re a toy manufacturing company and you sell $5 million in toys, your revenue for the year is $5 million.

Revenue doesn’t take into account any of the company’s expenses. For example, the toy manufacturing company may have spent $3 million to produce those toys, but that’s not reflected in its revenue.

That’s where profit comes in. Profit is the amount that’s left over after you subtract a company’s expenses and losses from its revenue. For example, the toy company’s profit is $2 million — $5 million in revenue minus $3 million in expenses.

A company’s retained earnings come from its profits. Let’s take this example a bit further. Of the $2 million in profit the toy company has, it has decided to pay its investors $1.5 million in dividends. The remaining $500,000 is its retained earnings.

Though there’s certainly a relationship between revenue and retained earnings, it’s not as direct. There are more important factors that go into retained earnings. For example, a company with high revenue may seem like it would have high retained earnings. But a company that spends every dollar it earns doesn’t have any profit left. Meanwhile, a company could have relatively low revenue, but also have low expenses that allow it to retain more of its earnings.

For companies with generally stable expenses, you would expect revenue to have more of a direct impact on retained earnings. In other words, the higher a company’s revenue for the year, the higher its retained earnings (assuming expenses and dividends remain stable).

Understanding negative retained earnings

Negative retained earnings occur when a company experiences a net income loss or when its losses and dividend payments exceed its net earnings and previous retained earnings.

Negative retained earnings can have major implications for both the business and its investors. First, negative retained earnings can make business growth difficult because there’s little cash available to reinvest in business growth and expansion. It also puts the company at risk because it doesn’t have a financial safety net in place.

From an investor’s perspective, negative retained earnings could be a sign that a company isn’t a good investment choice. It indicates that either the business is performing poorly or it's poorly managing the money it earns. Either way, a company with negative retained earnings is likely a less attractive investment opportunity than one with positive retained earnings.

Importance of retained earnings for business growth

Retained earnings is just one financial figure in a company’s makeup, but it’s still an important one. Retained earnings are a source of reinvestment and business growth for a company. The higher a company’s retained earnings, the more it can grow and expand. Especially for a company in its growth phase, retained earnings are critical.

Additionally, retained earnings help contribute to the financial stability and flexibility of a company. When a company faces a financial storm, having higher retained earnings gives it more leeway and can help it weather that storm better without having to resort to increased debt or other less favorable solutions.

As an investor, retained earnings are one of the many factors you should consider when evaluating different companies for investment.

Conclusion

Retained earnings are the share of a company’s profits it has left after paying dividends. A company’s total retained earnings are an important figure for both the business and its investors. The number appears on a balance sheet and can be an indicator of a company’s financial health and responsibility.

If you’re an investor and want to use retained earnings and other figures to analyze potential investments, consider using one of the many online stock analysis tools. Plenty of financial institutions offer such tools to their account holders. Alternatively, if you’re interested in a more balanced and diversified approach, consider investing in mutual funds or exchange-traded funds (ETFs) to avoid having to pick and choose individual stocks altogether.

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Jeremiah Forrest, CFP®

Contributor

Jeremiah Forrest is a Senior Financial Professional at Empower. A CERTIFIED FINANCIAL PLANNER™ professional, he works with Empower Personal Wealth investment clients and provides a wide range of financial planning services for clients who are enrolled in the Personal Strategy managed asset program. 

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