Retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. The word “retained” indicates that these earnings were not distributed to shareholders as dividends but were instead retained by the company.
For this reason, retained earnings decrease when a company either loses money or pays dividends and increase when new profits are generated.
Key Takeaways
- Retained earnings (RE) are the amount of net income left over for the business after it has paid out dividends to its shareholders.
- The decision to retain earnings or distribute them among shareholders is usually left to company management.
- A growth-focused company may use retained earnings to finance expansion activities rather than paying dividends.
- Companies may use retained earnings to increase production capacity, hire more sales representatives, launch new products, or conduct share buybacks.
- Retained earnings are significant for assessing a company’s financial health as they show saved net income for reinvestment or distribution.
Retained Earnings Formula and Calculation
\text{RE} = \text{BP} + \text{Net Income (or Loss)} - \text{C} - \text{S}
\text{where:}
\text{BP} = \text{Beginning Period RE}
\text{C} = \text{Cash dividends}
\text{S} = \text{Stock dividends}
What Can Retained Earnings Tell You?
Retained earnings reflect historical profits a company accumulated, subtracting dividends paid. Here are some uses of retained earnings:
- Distributed as dividends to shareholders.
- Reinvested in expanding existing operations, like increasing production capacity or hiring sales representatives.
- Invested in launching new products or variants.
- Used for mergers, acquisitions, or partnerships.
- Conducting share buybacks.
- Repaying outstanding loans or debts.
Management and Retained Earnings
The decision to retain earnings is usually left to the company management but can be challenged by shareholders. Reasons for retaining earnings may include high-growth projects that promise substantial returns. Alternatively, regular dividend income provides returns to long-term investors. Typically, management takes a balanced approach, paying nominal dividends and retaining a portion for growth._
Differences Between Retained Earnings and Dividends
Dividends, whether paid in cash or stock, reduce retained earnings. Cash dividends lead to cash outflow and lower the company’s asset value. In contrast, stock dividends transfer part of the retained earnings to common stock, decreasing the per-share valuation without impacting the company balance sheet significantly.
Differences Between Retained Earnings and Revenue
While revenue is the total income a company generates before expenses, retained earnings are the net cumulative profit after deducting dividends. Both are critical for evaluating financial health but highlight different aspects of financial performance.
Limitations of Retained Earnings
Analysts prefer observing retained earnings over a period to understand trends. Investors prefer knowing the returns from retained earnings and comparing them to alternative investments.
Evaluating Retained Earnings to Market Value
Analyzing the success of retained money involves comparing stock price changes with net earnings retained. For example, Apple’s stock price increased significantly from 2016 to 2020 due to effective use of retained earnings. Each dollar of retained earnings created significant market value.
Example of Retained Earnings
Public companies list retained earnings under shareholders’ equity on balance sheets. For instance, Apple’s balance sheet from fiscal Q3 of 2019 showed $53.72 billion in retained earnings. This value is calculated by adding net income to previous period retained earnings, subtracting dividends.
Types of Equity and Retained Earnings
Retained earnings are part of equity, reported in the shareholders’ equity section of the balance sheet. Although not an asset themselves, they can finance asset purchases or increase dividend payments.
Negative Retained Earnings Significance
Negative retained earnings indicate previous losses. Also, interpreting high retained earnings can be tricky, suggesting either financial strength or missed opportunities for shareholder dividends.
High Retained Earnings Impact
High retained earnings could indicate financial strength and profitability, or missed opportunities for distributing dividends depending on the company’s growth strategy.
Location of Retained Earnings on Balance Sheets
Retained earnings are found in the shareholders’ equity section. They are calculated by adding net income to starting retained earnings and subtracting dividends.
Distinction from Profits
The main difference is that retained earnings account for dividends, while profits indicate positive net income alone. Profits become retained earnings only when not distributed as dividends.
Conclusion
Retained earnings are crucial indicators of a company’s financial health and help promote stability and growth. They represent savings over time and can be reinvested for business expansion or paid to shareholders.
Related Terms: Shareholders’ Equity, Net Income, Profit, Dividend Payment, Revenue, Balance Sheet.
References
- Accounting Tools. “Retained Earnings Definition”.
- Financial Industry Regulatory Authority. “Get On Board: Understanding The Role of Corporate Directors”.
- Financial Industry Regulatory Authority. “Stocks”.
- Yahoo! Finance. “Apple Inc. (AAPL): Historical Data”. Select Date Range: September 1, 2016 to September 30, 2020.
- U.S. Securities and Exchange Commission. “Apple, Inc., Form 10-K, For the Fiscal Year Ended September 26, 2020”. Page 19.
- Apple Investor Relations. “Condensed Consolidated Statements of Operations (Unaudited): Q3, FY2019”. Page 2.
- Accounting Tools. “Retained Earnings Formula Definition”.
