Retained Earnings: Meaning, Factors & Examples

Every month, when you get your salary or your pocket money, what is the immediate next step? Budgeting. A part for the rent, one for investment, one for basic expenses, and the remaining for your goal of buying something you’ve been collecting money for long, correct? A similar thing happens in companies, too. They get their income for the year or month, pay the different expenses and liabilities, and keep the remaining as retained earnings. So, are retained earnings just the remaining component? What are these used for exactly, and how does understanding the retained earnings definition help investors choose the right company? Let’s check.

What do you mean by retained earnings?

Retained Earnings (RE) are the part of a business’s profits that aren’t given to shareholders as dividends. Instead, these profits are kept aside for reinvestment into the business. Companies usually use these funds for working capital, buying fixed assets (capital expenditures), or repaying debt.

Retained earnings are shown on the balance sheet under the shareholder’s equity section at the end of each accounting period. Now, due to the nature of both, retained earnings are often confused with reserves, but both are two different terms. Reserves and retained earnings are two different terms. While reserves come from retained earnings, they serve a specific purpose, like covering future debt. Plus, reserves are listed under liabilities on the balance sheet, while retained earnings appear under equity.

The companies sometimes prepare a separate report called the statement of retained earnings in addition to the usual balance sheet and income statement. This statement gives investors a clear picture of a company’s profitability and tracks the changes in retained earnings over time. It also helps investors get a quick view of how much profit the business is holding onto. How a business uses retained earnings can significantly impact its success, especially if it plans to grow. 

Retained Earnings Example and Formula:

Now, let’s move to the next part: How to calculate retained earnings? Retained earnings are computed using the following formula-

Retained earnings = Beginning retained earnings + Net income or loss - Dividends.

For example, let’s say a company starts the accounting period with Rs.7,000 in retained earnings from the previous period. It then makes a net income of Rs.5,000 and pays Rs.2,000 in dividends. The calculation would be:

Rs. 7,000 + Rs. 5,000 - Rs. 2,000 = Rs. 10,000.

This means the company has retained earnings of Rs.10,000 for the current period.

Retained earnings accumulate over a company's lifetime, carrying forward into each new period. If the company remains profitable, these earnings will likely grow, depending on how it uses them. 

In the company’s financial statements, the retained earnings look like this-

Factors Affecting Retained Earnings:

When evaluating retained earnings, it’s essential to consider the company's overall condition. For example, early-stage companies often have negative retained earnings, especially if they’ve borrowed funds or relied on investors. For older companies, negative retained earnings could mean they aren’t generating enough profit and may need financial assistance. Apart from this, some other factors to consider include-

• Company age: Older companies usually have higher retained earnings because they’ve had more time to accumulate profits.
• Dividend policy: Companies that regularly pay dividends may have lower retained earnings. Public companies tend to distribute dividends more often than private ones.
• Net Income: When net income goes up or down, or if there’s a net loss, it impacts the retained earnings, leading to either profitability or a deficit. If a business has large, ongoing net losses, the retained earnings account can become negative. Additionally, cash and non-cash items that affect the net income (sales revenue, operating expenses, stock-based compensations) affect the retained earnings indirectly.
• Seasonality: In industries like retail, companies may reserve profits during peak times to cover expenses during slower periods. This can lead to fluctuations in retained earnings, with some periods showing more savings and others less or even debt.

How can investors look at the retained earnings?

Retained earnings matter to both investors and businesses. At first, it might seem like investors wouldn’t like them since they mean the company isn’t paying dividends. However, in reality, retained earnings can actually attract more investors.

A company with a strong history of retained earnings indicates financial stability. This especially appeals to long-term investors looking for businesses with staying power. A consistent track record of retained earnings shows that the company could be around for the long haul. Retained earnings also act like a safety net for the companies. Just like having an emergency fund is wise for individuals, it helps companies prepare for tough times like economic downturns.

Bottomline

Retained earnings reflect a company’s financial health and responsibility. It can be used to pay dividends, invest in business growth, or saved as a safety net for tough times. While retained earnings are important, they should not be viewed in isolation. They are part of a bigger financial picture that gives insight into your company’s overall performance. Understanding how retained earnings fit with other financial metrics helps guide smarter business decisions for long-term success and sustainability.

FAQs

Q1. What are the limitations of retained earnings? 

Ans. Firstly, shareholders may feel dissatisfied due to lower dividends if a business keeps too much profit as reserves. Relying on retained earnings is uncertain, as profits can fluctuate. Lastly, many firms overlook the opportunity cost of using retained profits, resulting in less effective use of funds.

Q2. What are the components of retained earnings?

Ans. Retained earnings have three main components. First, there are the beginning retained earnings from the previous period. Second, we add or subtract the net profit or net loss from the current accounting period. Lastly, we account for any cash and stock dividends paid out during the same period.

Q3. Can retained earnings be negative?

Ans. A retained earnings account can have a negative balance. This situation occurs when a business has faced net losses or paid out more dividends than what is available in its retained earnings account.