What are retained earnings?
Retained earnings are an essential concept in accounting. The term refers to the historical profit earned by a company less any dividends previously paid. The word ‘unsustainable’ reflects that, since that income was not paid out as dividends to shareholders, it remained with the company. Hence, retained earnings decrease when a company loses cash or pays dividends and increases when new profits arise.
Retained earnings formula and calculation
RE=BP+Net Income (or Loss)−C−S
where:
BP=Beginning Period RE
C=Cash dividends
S=Stock dividends
What retained earnings can tell you
The following options cover, in general, all the possible uses that a company can make of its cash surplus. The first option would result in the cash being lost forever from the company’s accounts because the dividend payments are irreversible.
All other options leave income for internal use, and such investments and financing activities constitute retained earnings (RE).
– Income can be distributed (in full or in part) between business owners (shareholders) as dividends.
– It can be used to expand current enterprises, such as increasing the manufacturing capacity of existing items or hiring salespeople.
– It can be invested in bringing a new product/variant to markets, such as a refrigerator manufacturer that will produce air conditioners or a chocolate chip cookie manufacturer that will market orange or pineapple flavors.
– The money can be used for any potential merger, acquisition, or partnership that will lead to better business prospects.
– It can also be used to buy the stocks back.
– The income can be used to repay any outstanding loans (debts) of the company.
Retained earnings are the cumulative net profit of the enterprise or profit after dividend payments. It is also called surplus income and is reserve money that is available to the company’s management to reinvest in the company. When it is expressed as a percentage of total income, it is also called the withholding rate and is equal to (1 – dividend payout ratio).
Although the latter option to repay the debt also results in a cash outflow from the entity, it does have an effect on the entity’s accounting (for example, saving future interest payments that qualify for retained earnings).
Profits give the business owner (s) or management a lot of room to use the surplus money earned. These profits are often paid out to shareholders but can also be reinvested in the company for growth. Unpaid money to shareholders goes to retained earnings.
Retained earnings target
Retained earnings are a useful link between the income statement and the balance sheet because they are recognized in equity that combines the two statements. The purpose of maintaining these revenues may be different and include the purchase of new equipment and machinery, expenditure on research and development, or other activities that could potentially generate growth for the enterprise. The aim of this reinvestment in the company is to generate even more profits in the future.
If an entity does not believe that it will be able to earn a sufficient return on that retained earnings (i.e., earn more than its cost of capital), it will often distribute that dividend to shareholders or arrange for the repurchase of shares.
Beginning of the period Retained earnings
At the end of a certain reporting period, retained earnings are recognized in the balance sheet as accumulated income for the previous year (incl. Income for the current year), less dividends paid to shareholders. The ending balance of the RU from the previous accounting period becomes the initial balance of retained earnings in the current accounting cycle.
The RU’s balance may not always be a positive number, as this may reflect a higher net loss for the current period than the RU’s opening balance. Alternatively, a large distribution of dividends in excess of the retained earnings balance may result in a negative dividend.
How net income affects retained earnings
Any change or movement in net profit directly affects the balance of the property. Increases or decreases in net income, as well as the occurrence of a net loss, all contribute to a company’s profitability or deficit. The retained earnings account may be negative due to large cumulative net losses. Of course, RUs are affected by the same items that affect net profit.
These include, for example, sales revenue, cost of goods sold, depreciation, and other operating expenses. The account is also affected by non-monetary items such as discounts or rebates and share-based compensation.
How dividends affect retained earnings
Dividends may be distributed to shareholders in the form of cash or shares. Both forms can reduce the value of the RU for the company. Cash dividends are cash outflows and are recorded in the cash account as reductions. They reduce the size of the company’s balance sheet and the value of its assets, as the company no longer has a share of its liquid assets.
However, equity dividends do not require cash outflows. Instead, they redistribute part of the RE to ordinary shares and additional paid-in capital accounts. The total size of the company’s balance sheet is unaffected by this distribution, but the value of the shares per share is reduced.
Is retained earnings a type of equity?
It is a type of equity and is therefore recognized as equity in the balance sheet. Although retained earnings are not assets themselves, they can be used to purchase assets such as inventories, equipment, or other investments. As a result, a company with high retained earnings may be in a favorable position to buy new assets or pay bigger dividends to its shareholders in the future.
What do high retained earnings mean for a company?
On the one hand, high retained earnings may indicate financial strength, as it reflects the profitability of previous years. On the other side, it could suggest that management is having trouble finding viable investment alternatives for the company’s retained earnings. In these circumstances, shareholders could prefer management to pay out its retained earnings simply as dividends.
