Updated July 11, 2023
What are Retained Earnings?
Retained Earnings (RE) can be defined as the earnings that the business retains with itself and are not used for distributing profits as dividends. The profits retained by the company are generally utilized to be re-invested back in the industry. Such profits may be used to finance tangible assets, debt obligations pay-off, and working capital requirements.
Explanation
RE is residual profits that the business retains with itself, and such profits are not distributed as dividends to the company’s shareholders. The value of retained earnings is always impacted by a positive net income or a negative net loss. The positive value of retained earnings is always regarded as favorable, and this helps to attract new investors who may be interested in investing in the business. It generally indicates that the company has surplus money and can generate surplus income yearly. The business management typically exercises their best judgment to determine how much they should distribute to shareholders as dividends and how much earnings they should retain as RE. The ending balance of the retained earnings is arrived at by adding or subtracting net income or loss from the beginning balance of retained earnings, followed by the deduction of cash and stock dividends.
Purpose of Retained Earnings
Business generally maintains RE to have some cash cushion for themselves. The company may have plans to finance small projects and business requirements from the earnings the firm has retained. More broadly, RE is earnings generally re-invested in the industry to earn better results and returns. Such earnings that are re-invested in the business may be utilized for corporate actions such as share buybacks, the pay-off of any outstanding debt, and performing mergers and acquisitions of the companies that are strategically important in revenue growth and competition elimination. The RE may further be utilized for distributing dividends to the shareholders for the coming financial years if the business finds itself in a stiff position to generate income levels in the following financial years.
Formula for Retained Earnings
The RE can be determined using the below relationship as displayed below: –
How to Calculate Retained Earnings?
The following are the steps to be employed when determining the RE: –
- The first step starts with accessing the beginning balance of the stockholder’s equity from the balance sheet.
- The next step involves accessing the net income from the income statement generated by the business for the financial year.
- Add the net income to the initial balance of the RE.
- Deduce any potential cash and stock dividends as approved by the management from the updated balance of RE to arrive at the remaining balance of the retained earnings.
Example of Retained Earnings
Let us take the example of ABC corporation. The business has the beginning balance of retained earnings as $32,000. The business earns a net income of $20,000 for the current financial year. The management decided to keep $8,000 as dividends from the net income earned. Help the management determine the ending balance of the RE: –
Solution:
The final Value of RE is calculated as
Final Value of RE = Initial Balance + Net Income – Dividends
- Final Value of RE = $32,000 + $20,000 – $8,000
- The final value of RE =$44,000
Dividends Impact Retained Earnings
The dividends are residual profits distributed to the shareholders and can always be distributed to the shareholders in the form of stock and cash. Therefore, the value of the dividends does impact the retained earnings. The ending balance of RE is determined only after the dividends are deducted from the initial levels of the retained earnings plus any net income earned by the business for a given financial year. The cash dividends always result in a cash outflow for the company. Since the industry has reduced value in terms of the overall position of the liquid assets, this, in turn, impacts the RE of the business. Compared with stock dividends, such dividends do not affect the business’s cash position.
Rather, payment of stock dividends results in the transfer of some portion of the RE concerning the common stock. Suppose when a business delivers one stock as a dividend for each stock held by the shareholder. The price of the share as quoted would reduce to half as the practical value remains exact, but the number of overall values of the shares has increased. Since there is a valuation reduction per share, it impacts the capital account, thereby impacting the RE.
Retained Earnings vs Net Income
The net income is generally added to the RE account. RE can be classified as collecting the business’s net income. It signifies all the net income the company retained through the financial years going concerned. Suppose for each financial year, the beginning balance of RE is taken from the balance sheet, generally as of the date, and the net income earned by the business for the financial year is taken from the income statement of the same financial year. To the beginning balance, add net income to arrive at the actual value of retained earnings. It is regarded as the actual value when a business shows or displays no interest in distributing some part of net income as dividends to the shareholder. If the company distributes dividends, the updated value would further be deducted with the corresponding value of dividends to arrive at the remaining balance of the retained earnings.
Advantages
Some of the significant advantages are as follows:
- It helps in attracting new prospective investors to the business.
- It helps finance new projects in the pipeline as RE fortifies the company’s internal resources.
- It can also be used to finance the working capital requirements.
- It can be used to finance Adhoc business requirements.
Disadvantages
Some of the major disadvantages are as follows:
Investors should not blindly look into the retained earnings levels when assessing the RE. The reason is that the absolute value of RE, as showcased for a particular year or a quarter, does not generally provide meaningful insights. It is a very high-level indicator of how the business performs and generates revenues for the continuous financial years.
Conclusion
It can be defined as the earnings the business retains with itself and does not distribute to the shareholders as dividends. The RE balance can continuously be tracked under the stockholder’s equity portion of the balance sheet.
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