Retained Earnings: A Complete Guide

Retained earnings reflect the net profit remaining in the company after dividends are paid to shareholders. Therefore, the retained earnings statement will affect everything that affects net income, such as operating costs, depreciation, and expense on items sold.

The retained earnings are available to pay extraordinary dividends, finance business growth, invest in a new product line, or even repay debt. 

Most companies with a healthy balance let us try to find the right combination so that shareholders are satisfied and, at the same time, finance business growth.

What is the meaning of retained earnings? 

Retained earnings are the net profit that the company will retain after paying dividends to investors and other distributions. These retained earnings are what the company will keep. 

If there is a surplus of retained earnings, the company may decide to use this money for factors that will support its growth. Retained earnings can also be called "unintended income over-income" or "accumulated income."

The retained earnings are best to determine if the business is profitable. Because these revenues are the remainder of all liabilities, the last retained earnings indicate the company's actual value. 

If a company maintains positive profits, it has excess income that it can reinvest. Conversely, a negative profit means that the company has accumulated a deficit and is more indebted than the company's income.

How do retained earnings work?

Because retained earnings show a profit after all obligations have been met, retained earnings indicate whether the company is making a profit and can invest independently. These reinvestments can help increase future income.

A company with negative retained earnings has an accumulated deficit, which means more debt than earned income. Private and public companies face various pressures in terms of sustainable profits, although dividends may not be clear.

Public companies have many shareholders who actively sell the company's shares. While saved profits can help improve a company's financial health, dividends can help attract investors and keep stock prices high.

If a company pays dividends for one year, it will reduce the following year to increase residual income, making it more challenging to attract investors.

Increasing the dividends at the expense of retained earnings will help bring in some new investors. However, the investors also want to see a financially strong company that can grow, and the effective use of retained earnings can yet show investors that the company is expanding.

Public companies must therefore keep a balance sheet of their income and dividends. The combination of dividends and reinvestment is best to satisfy investors and keep their enthusiasm for the company's direction without sacrificing the company's goals.

Are the retained earnings the same as the reserves?

Reserve accounts are taken from retained earnings, but the critical difference is that reserves have a fixed purpose, such as repaying expected debt in the future. 

Provisions can be found in the balance sheet in the liabilities part, while residual income is part of shares. It is also possible to prepare a retained earnings statement with a proper balance sheet and a profit and loss statement.

In particular, it helps investors gain an overview of the company's income. The statement of saved earnings is often straightforward.

How to calculate the retained earnings?

The formula for calculating retained earnings is as follows:

Retained earnings= initial retained earnings + net income as loss - dividends

For example, a business may begin an accounting period with retained earnings of $ 7,000. These are the retained earnings from the previous accounting period.

The company then generates a net income of $ 5,000 and a total dividend payment of $ 2,000. The calculation would be $ 7,000 + $ 5,000 - $ 2,000 = $ 10,000. Thus, the company maintains revenues of USD 10,000 during this accounting period.

The company's retained earnings are collected and transferred in each new accounting period or year. 

If a company makes a huge profit, it will likely have savings that increase during each accounting period depending on how it decides to use the retained earnings profit.

Steps to prepare and maintain retained earnings 

Generally accepted accounting principles provide a standardized presentation format for the retained earnings statement. Steps to follow for creating a statement are:

1. Header: Consists of three lines. The first contains the company name. The second is the report's title: "Retained Earnings Statement." And the third explains the fiscal year for reported retained earnings, such as "Fiscal year ended 2020".

2. Starting with the previous year's retained earnings: This is the first item in this statement, showing the retained earnings from the previous year's balance! This is now called the beginning of saved earnings. Pre-adjustment of the period: Optional, such as an error in the depreciation calculation.

3. The retained earnings balance is less than any required changes: This is the new amount of retained earnings introduced after adjusting for errors.

4. Net profit: This record in this statement comes from the profit and loss statement of the current year (the year in which the income is calculated in this statement).

5. Enter a dividend payment: A dividend is any payment made to shareholders. This third record shows the total dividend payment for this accounting period. This number is taken from the subtotal by adding the above items.

6. End of retained earnings: This item is the total deduction of dividend payments from net profit + initially retained earnings.

7. Other information: This optional part of the statement is intended for notes on details that affect the payment of dividends, such as share purchases, recent share issues, or other important information.

How do dividends affect retained earnings?

Dividend payments to shareholders may be in the form of cash or shares. Both forms can reduce the RE value for the company. Cash dividends represent an outflow of cash and are recognized as deposits in cash accounts. 

Hence, this reduces the company's balance sheet size and the value of its assets, as the company no longer has part of its liquid assets.

However, share dividends do not require a cash outflow. Instead, they transfer part of the RE to ordinary shares and additional paid-in capital accounts. As a result, this allocation does not affect the overall size of the company's balance sheet but reduces the value of shares per share.

Retained earnings vs. revenue 

Revenue is the income from the sale of goods or services and is the main item in the income statement.

On the other hand, retained earnings are derived from the final result as a description of income gains. They are an essential element of a shareholder's share in the company's balance sheet and book value. Its main differences are:

• Revenue is income, while retained earnings include the cumulative amount of net profit achieved for each period, net of shareholder distributions.

• In some cases, shareholders may prefer to reinvest in the company instead of paying dividends despite the negative tax consequences. Revenue is the highest item in the income statement; Retained earnings represent a portion of the equity on the balance sheet.

• Sales reflect market demand for the company's goods or services.

• Retained earnings are keys to determining equity and calculating the company's carrying amount.

How to interpret the results of calculations of retained earnings?

The retained earnings represent profit when all dividends and other liabilities are met. If the company's retained earnings are positive, it has an income. If a company has negative retained earnings, it has accumulated more debt than it has generated in revenue.

When interpreting retained earnings, it is essential to look at the result concerning the company's general situation. For example, negative income can be expected if the company is in the first years of business.

Thus, this is especially true if the company lends or relies heavily on investors to get started.

However, if the company has been in business for many years, a negative retained earning can signify that the company is not making enough profit and needs financial help. When translating retained earnings, consider the following factors:

• Business age: Higher companies have more time to accumulate retained earnings and therefore need a higher income.

• Dividend policy of the Company: If the Company promises the regular payment of dividends, it may have lower retained earnings. Many public companies pay more dividends than private companies.

• Company profit: The higher the company profit, the higher the average retained earnings.

• Business seasonality: In industries where business is highly seasonal, such as retail, companies may need to reserve and retain profits during their profit periods. Thus, a company may have an accounting period with high retained earnings and an accounting period with lower or negative retained earnings.

Limitations of retained earnings

The absolute number of earnings earned in a given quarter or year may not provide a meaningful overview for analysts. 

As an investor, you want to know much more about the return on retained earnings and whether it is better than any alternative investment. In addition, investors would rather see more enormous dividends than significant annual increases in retained earnings.

Ways of using retained earnings

You can use the retained earnings in many different ways. For example, you can invest this net income in new activities that we can generate or use as working capital. 

Thus, you can buy new commercial property such as equipment, machinery, real estate, or cars. You can also defer these earnings to pay off debt obligations. Here are some examples:

• Launching any new line of products or services: Startup promoters will inevitably reach the point where they will have to expand their product line and audience or risk-reducing staffing. Retained earnings represent an opportunity to develop this second successful product.

• Expand your business: hire more employees, open a new location, upgrade your office location, or if you are not expanding your operations yet.

• Repay debts, loans, or other forms of credit: Continue to repay the debt of a small business.

• If your company can afford it, the repayments will be attractive to current and future investors.

What are the benefits of retained earnings?

Retained earnings include the following key benefits:

• Useful for expansion and diversification: Retained earnings are most beneficial for business expansion and diversification. Economic sources of financing: Retained earnings are one of the least expensive sources of financing because they do not involve variable costs, as is the case with raising funds by issuing different types of securities.

• No fixed obligation: If companies use equity financing, they have to pay dividends, and if companies use debt financing, they have to pay interest. However, if the company uses the remaining proceeds as financial resources, no specific obligation to pay dividends or interest may apply.

• Flexible resources: Retained earnings can keep the financial structure fully flexible. The company does not have to take out loans for additional requirements if it has retained earnings. Increase in share value: If a company uses retained earnings as a source of financing for its financial needs, the cost of capital is cheaper than other sources of financing; the value of the part will therefore increase.

• Avoid excessive taxation: Retained earnings allow a company to avoid excessive taxation with few shareholders.

• Increase revenue capacity: Retained earnings involve minimal capital costs and are best suited for companies to diversify and expand.

What are the common disadvantages of retained earnings?

Retained earnings also have some disadvantages:

• Abuse: Management can abuse profits by manipulating the value of stocks in the stock market.

• Leads to a monopoly: Excessive use of retained earnings leads to a monopolistic nature of society. Excess capitalization: Retained earnings lead to a surplus of capital because if a company uses more residual income, it will lead to an insufficient source of financing.

• Tax evasion: Retained earnings lead to tax evasion because the company reduces the tax burden of content earnings.

• Dissatisfaction: If the Company uses retained earnings as a source of financing, the shareholder will not receive any further dividends. Thus, the shareholder does not want to use the remaining income as a financial source in all situations. 

Is it valuable for new businesses?

The retained earnings statement is highly sought after by two main groups: investors and creditors. This is because most startups rely on funding from these two sources to achieve the goals of aggressive growth, rapid expansion, and the creation of business credit.

First, investors want to see rising dividends as stock prices rise. Although they are shareholders, they have taken a few steps out of the case. The retained earnings statement is a specific way to determine if their investment is paying back.

By comparing retained earnings over time, investors can better predict future dividend payments and price share improvements.

Second, lenders and lenders are constantly looking for evidence that a business can settle debts and repay the loan. Therefore, business owners need to build a positive relationship with these two groups so that they lose ground and can continue to grow.

Related Questions: (FAQs)

What are the limits of retained earnings? 

Retained earnings limits are as follows: Unbalanced growth occurs because retained earnings remain in the same sector. In addition, because retained earnings fluctuate from time to time, it is an uncertain source of finance.

Are retained earnings an asset?

No, the retained earnings are not considered an asset on the balance sheet. They are reported as a line item in the shareholders' balance sheet instead of the assets section. Although you can reinvest the retained earnings as assets, they are not assets per se.

Can I withdraw the retained earnings?

When a company withdraws money from retained earnings to give to shareholders, it is called a dividend payment. The company first declares that the dividends are due, with an entry being made to the account of retained earnings and payment to the account of the dividends payable.

What will happen to the retained earnings at the end of the year? 

At the end of the fiscal year, the entire balance of each temporary account is transferred to retained earnings, which is a standing account, using the closing records. The net amount of the transferred balances includes the gain or loss that the company received.

What should I do with my saved income?

The retained earnings are available to pay extraordinary dividends, finance business growth, invest in a new product line, or even repay debt. So most companies with a healthy balance let us try to find the right combination so that shareholders are satisfied and, at the same time, finance business growth. 

Final thoughts

Knowing and understanding the value of retained earnings can help a company grow. But more than that, those who want to invest in a business will undoubtedly expect the owner or the manager to understand its value because they do not only invest in the business; they also invest in it.

And if they don't care about basic accounting things, it may seem like a sign of bad traffic.

In some cases, a company may choose not to spend funds but instead use the retained earnings to create a reserve. As a result, they protect the company from future emergencies or downturns or save on significant future expenses, such as purchasing expensive capital equipment.