Retained earnings

Definition

Retained earnings refer to the portion of a company’s net income that is not distributed to shareholders as dividends but is instead retained and reinvested in the business. 

What are retained earnings?

Retained earnings represent the sum of all past profits that have been reinvested in the company since its beginning, minus any dividends or other distributions to shareholders. They serve as a source of internal financing for various purposes such as funding expansion projects, research and development, debt repayment, or other investments aimed at increasing the company’s value and competitiveness in the market.

Retained earnings accumulate over time as a result of profitable operations. They are derived from the net income generated by the company after deducting all expenses, taxes, and dividends.

While retained earnings are not directly distributed to shareholders, they contribute to increasing shareholder value in the long run. By reinvesting profits into the business and generating higher returns, companies can potentially boost stock prices and create wealth for shareholders over time.

The decision regarding how much of the net income should be retained and how much should be distributed as dividends is influenced by various factors. A company may choose to retain more earnings during growth phases to fuel expansion, while mature companies with stable cash flows may opt to distribute a higher portion of earnings as dividends to reward shareholders.

How to calculate retained earnings

Retained earnings are calculated by taking the beginning retained earnings balance, adding net income or subtracting net loss for the period, and then subtracting any dividends paid to shareholders. The formula is:

Retained earnings = Beginning retained earnings – Net income (or – net loss) – Dividends paid

This calculation provides the amount of profit that has been reinvested in the company rather than distributed to shareholders, reflecting the company’s ability to generate and retain profits over time.

What does negative retained earnings mean?

Negative retained earnings indicate that a company has accumulated more losses than profits over time, resulting in a deficit. This situation, often referred to as an “accumulated deficit,” means the company has experienced financial difficulties, possibly due to consistent net losses or substantial dividend payments exceeding its net income.

Negative retained earnings can signal potential financial instability and may affect the company’s ability to invest in growth, pay dividends, or secure financing. It is a critical metric for stakeholders to assess the company’s long-term financial health and profitability.

Retained earnings vs. dividends

Retained earnings and dividends are related components of a company’s financial management. Retained earnings represent the profits that a company has reinvested in the business rather than distributing to shareholders. These funds are used for growth, debt reduction, or other operational needs. Dividends, on the other hand, are portions of a company’s profits paid out to shareholders as a return on their investment. While retained earnings help strengthen the company’s financial position, dividends provide immediate returns to investors.

Retained earnings vs. revenue

Retained earnings and revenue are distinct financial metrics. Revenue refers to the total income generated from the sale of goods or services before any expenses are deducted. It represents the top line of a company’s income statement. Retained earnings, however, are the net profits that remain after dividends have been paid to shareholders. These are reported on the balance sheet under shareholders’ equity. While revenue indicates a company’s ability to generate sales, retained earnings show how much profit has been reinvested in the business for growth and operations over time.

Example of retained earnings

At the beginning of the year, ABC Inc. has retained earnings of £500,000. Throughout the year, the company generates a net income of £200,000 from its operations.The company decides to retain a portion of this profit to reinvest in its growth initiatives.

Assuming ABC Inc. does not distribute any dividends during the year:

Retained earnings (End of year) = £500,000 (Beginning of year) + £200,000 (Net income) – £0 (Dividends)

Retained earnings (End of year) = £700,000

So, at the end of the year, ABC Inc. would have retained earnings of £700,000.