Retained Earnings: Definition, Calculation, and Significance
Definition of Retained Earnings
Retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. They represent the portion of a company’s earnings that are retained and saved for future use, rather than being distributed to shareholders as dividends.
Key Facts
- Definition: Retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments.
- Not Cash: Retained earnings are not the same as cash or the business bank account balance.
- Calculation: Retained earnings can be calculated using the formula: Beginning Period RE + Net Income (or Loss) – Cash Dividends – Stock Dividends.
- Uses of Retained Earnings: Companies can use retained earnings for various purposes, such as financing expansion activities, increasing production capacity, launching new products, share buybacks, or repaying outstanding loans.
- Financial Health Indicator: Retained earnings are an important variable for assessing a company’s financial health as it shows the net income that a company has saved over time and its ability to reinvest in the business or distribute to shareholders.
- Management Decision: The decision to retain earnings or distribute them among shareholders is usually left to company management, but it can be challenged by shareholders through a majority vote.
- Impact on Shareholders: Retained earnings can be distributed to shareholders in the form of dividends or reinvested back into the company for growth purposes.
- Difference from Dividends: Dividends can be distributed in the form of cash or stock, and both forms reduce retained earnings. Cash dividends lead to cash outflow, while stock dividends transfer part of the retained earnings to common stock.
- Relationship with Revenue: Retained earnings are related to net income, which is the revenue minus operating expenses and overhead costs. It represents the portion of cumulative profit held or retained by the company for future use.
- Limitations: The absolute figure of retained earnings in a particular period may not provide meaningful insight. Analyzing the trend of retained earnings over time can provide a better understanding of a company’s financial performance.
Calculating Retained Earnings
The formula for calculating retained earnings is as follows:
Beginning Period RE + Net Income (or Loss) – Cash Dividends – Stock Dividends
where:
- Beginning Period RE: Retained earnings at the start of the accounting period
- Net Income (or Loss): The company’s net income or loss for the accounting period
- Cash Dividends: The amount of cash dividends paid to shareholders during the accounting period
- Stock Dividends: The amount of stock dividends paid to shareholders during the accounting period
Uses of Retained Earnings
Retained earnings can be used for various purposes, including:
- Financing expansion activities: Retained earnings can be used to fund the expansion of the company’s operations, such as opening new stores or launching new product lines.
- Increasing production capacity: Retained earnings can be used to purchase new equipment or machinery to increase the company’s production capacity.
- Launching new products: Retained earnings can be used to develop and launch new products or services.
- Share buybacks: Retained earnings can be used to buy back shares of the company’s own stock, which can increase the value of the remaining shares.
- Repaying outstanding loans: Retained earnings can be used to repay outstanding loans, reducing the company’s debt burden.
Retained Earnings as an Indicator of Financial Health
Retained earnings are an important variable for assessing a company’s financial health. A company with a large amount of retained earnings is generally considered to be financially healthy, as it has the resources to invest in its future growth and to withstand economic downturns.
Management and Retained Earnings
The decision to retain earnings or distribute them among shareholders is usually left to company management. However, shareholders can challenge this decision through a majority vote. Management may choose to retain earnings for various reasons, such as to fund growth initiatives or to reduce the company’s debt burden. Shareholders may prefer to receive dividends, as this provides them with a return on their investment.
Impact of Retained Earnings on Shareholders
Retained earnings can be distributed to shareholders in the form of dividends or reinvested back into the company for growth purposes. Dividends are payments made to shareholders out of the company’s profits. Reinvesting retained earnings back into the company can lead to increased profitability in the future, which can benefit shareholders in the long run.
Difference Between Retained Earnings and Dividends
Dividends are payments made to shareholders out of the company’s profits, while retained earnings are the portion of earnings that are retained by the company for future use. Dividends reduce retained earnings, as they represent a distribution of profits to shareholders.
Relationship Between Retained Earnings and Revenue
Retained earnings are related to net income, which is the revenue minus operating expenses and overhead costs. It represents the portion of cumulative profit held or retained by the company for future use.
Limitations of Retained Earnings
The absolute figure of retained earnings in a particular period may not provide meaningful insight. Analyzing the trend of retained earnings over time can provide a better understanding of a company’s financial performance.
References
- https://www.legalzoom.com/articles/what-is-retained-earnings-how-to-calculate-them
- https://www.investopedia.com/terms/r/retainedearnings.asp
- https://www.freshbooks.com/hub/accounting/is-retained-earnings-an-asset
FAQs
What are retained earnings?
Retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. They represent the portion of a company’s earnings that are retained and saved for future use, rather than being distributed to shareholders as dividends.
Are retained earnings the same as cash?
No, retained earnings are not the same as cash. Retained earnings are a part of a company’s equity, while cash is a current asset. Retained earnings are not necessarily held in cash, but may be invested in various assets or used to reduce liabilities.
How are retained earnings calculated?
Retained earnings are calculated using the following formula:
Beginning Period RE + Net Income (or Loss) – Cash Dividends – Stock Dividends
What are the uses of retained earnings?
Retained earnings can be used for various purposes, including financing expansion activities, increasing production capacity, launching new products, share buybacks, or repaying outstanding loans.
Why are retained earnings important?
Retained earnings are important because they provide a company with the resources to invest in its future growth and to withstand economic downturns. A company with a large amount of retained earnings is generally considered to be financially healthy.
Who decides how retained earnings are used?
The decision to retain earnings or distribute them among shareholders is usually left to company management. However, shareholders can challenge this decision through a majority vote.
How do retained earnings impact shareholders?
Retained earnings can be distributed to shareholders in the form of dividends or reinvested back into the company for growth purposes. Dividends provide shareholders with a return on their investment, while reinvesting retained earnings can lead to increased profitability in the future, which can also benefit shareholders.
What is the difference between retained earnings and dividends?
Retained earnings are the portion of a company’s earnings that are retained and saved for future use, while dividends are payments made to shareholders out of the company’s profits. Dividends reduce retained earnings, as they represent a distribution of profits to shareholders.