What Are Retained Earnings?
Retained Earnings Are Important, but How They're Used Is Critical
You'll find a line item called retained earnings, or less commonly called accumulated earnings, earnings surplus, or unappropriated profit on a company's balance sheet under the shareholders' equity section.
Retained earnings represent the portion of net income or net profit on a company's income statement that are not paid out as dividends. Rather, these earnings are retained in the company. Retained earnings are often reinvested in the company to use for research and development, replace equipment, or pay off debt.
Components of Retained Earnings
Retained earnings are accumulated and tracked over the life of a company. What this means is as each year passes, the beginning retained earnings are the ending retained earnings of the previous year. Retained earnings are leftover profits after dividends are paid to shareholders, added to the retained earnings from the beginning of the year.
Beginning Retained Earnings + (Profits or Losses) - Dividends = Retained Earnings
Retained Earnings Defined
Since retained earnings demonstrate profit after all obligations are satisfied, retained earnings show whether the company is genuinely profitable and can invest in itself. Retained earnings are generally reinvested into a company.
If a company has negative retained earnings, it has an accumulated deficit.
An accumulated deficit means a company has more debt than it has earned. As with many of the financial performance measurements, this must be taken into context with the company's general situation.
If it has been operating for more than a few years, it is likely to be in need of financial assistance. If the business is less than a few years old, it is likely still working on getting ahead of debt. A more senior company would not be in a financially stable position with an accumulated deficit.
To Pay or Retain
Private companies are able to do what they want with their retained profits (within federal guidelines), but publicly-held companies face a conundrum. If they have acquired funding through investing methods, shareholders and investors will want some return on their investment.
This leaves a company at a decision point—should they retain their earnings and reinvest in the company, or should they pay their shareholders dividends?
If a company would like to keep its flow of financial aid, it would be a good choice to pay dividends to continue attracting investors. However, companies are not required to pay dividends, so the company could keep the earnings and use them to expand.
Expansions could cause the value of the company's shares to increase, making investors happy. A combination of the dividends and reinvestment could be used to satisfy both investors and company goals.
For a young small business, the choice might be simpler. If you have received funding from investors, but still need to grow to turn sales into profit, you might want to keep your earnings and reinvest in your company. If your small business has been around a while and can afford dividends, giving your investors some payback might be a good choice.