Retained earnings represent the portion of net profit on a company's income statement that is not paid out as dividends. These retained earnings are often reinvested in the company, such as through research and development, equipment replacement, or debt reduction.
Below, you'll find the formula for calculating retained earnings and some of the implications it has for both businesses and investors.
What Are Retained Earnings?
Retained earnings are any profits that a company decides to keep, as opposed to distributing them among shareholders in the form of dividends. Dividends can be paid out as cash or stock, but either way, they'll subtract from the company's total retained earnings. Retained earnings are often used for business reinvestment.
Retained earnings can be used to shore up finances by paying down debt or adding to cash savings. They can be used to expand existing operations, such as by opening a new storefront in a new city. No matter how they're used, any profits kept by the business are considered retained earnings.
You'll find retained earnings listed as a line item on a company's balance sheet under the shareholders' equity section. It's sometimes called accumulated earnings, earnings surplus, or unappropriated profit.
How Do You Calculate Retained Earnings?
Retained earnings are accumulated and tracked over the life of a company. The first figure in the retained earnings calculation is the retained earnings from the previous year. Once you know the retained earnings that you started the fiscal year with, you add the profits (or losses) from the current year, subtract any dividend payments, and that gives you the retained earnings for the current year.
How Retained Earnings Work
Since retained earnings demonstrate profit after all obligations are satisfied, retained earnings show whether the company is genuinely profitable and can invest in itself. Those reinvestments can help boost future profits.
If a company has negative retained earnings, it has accumulated deficit, which means a company has more debt than earned profits.
Private and public companies face different pressures when it comes to retained earnings, though dividends are never explicitly required. Public companies have many shareholders that actively trade stock in the company. While retained earnings help improve the financial health of a company, dividends help attract investors and keep stock prices high.
If a company issued dividends one year, then cuts them next year to boost retained earnings, that could make it harder to attract investors. Increasing dividends, at the expense of retained earnings, could help bring in new investors. However, investors also want to see a financially stable company that can grow, and the effective use of retained earnings can show investors that the company is expanding.
Therefore, public companies need to strike a balancing act with their profits and dividends. A combination of dividends and reinvestment could be used to satisfy investors and keep them excited about the direction of the company without sacrificing company goals.
For a small or new business, the choice is usually simpler. Any investors—if the new company has them—will likely expect the company to spend years focusing the bulk of its efforts on growing and expanding. There's less pressure to provide dividend income to investors because they know the business is still getting established. If a young company like this can afford to distribute dividends, investors will be pleasantly surprised.
Limitations of Retained Earnings
As with many financial performance measurements, retained earnings calculations must be taken into context. Analysts must assess the company's general situation before placing too much value on a company's retained earnings—or its accumulated deficit.
If the company has been operating for a handful of years, an accumulated deficit could signal a need for financial assistance. For established companies, issues with retained earnings should send up a major red flag for any analysts. On the other hand, new businesses usually spend several years working their way out of the debt it took to get started. An accumulated deficit within the first few years of a company's lifespan may not be troubling, and it may even be expected.
- Retained earnings are the profits that a company generates and keeps, as opposed to distributing among investors in the form of dividends.
- Retained earnings are usually reinvested in the company, such as by paying down debt or expanding operations.
- Companies are not obligated to distribute dividends, but they may feel pressured to provide income for shareholders.
- When retained earnings are negative, it's known as an accumulated deficit.