Retained earnings: How does it work?

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.

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.