Retained Earnings (Accounting) - Explained
What are Retained Earnings?
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Table of ContentsWhat are Retained Earnings?How is Retained Earnings Used?How to Calculate Retained Earnings Retained Earnings FormulaRetaining vs Paying the Retained EarningsImpact of dividends on REHow retained earnings are interpretedSummaryAcademic Research for Retained Earnings
What are Retained Earnings?
Retained earnings, also known as Accumulated Earnings or Accumulated Earnings and Profits, can be defined as a company's accumulated surplus or profits after paying out the dividends to shareholders.
Generally, Retained earnings represents the company's extra earnings available at management's disposal. In most cases, the management uses this reserve money to reinvest back into the business or give it out to settle the company's debt.
Note that even though debt payment results in money going out, it is also a way of saving for future interest payment since the burden is reduced and future earnings will be retained.Therefore, debt payment qualifies as part of retained earnings.
How is Retained Earnings Used?
A business generates earnings in the form of profits or losses. However, generating profits opens more ways which management can use to utilize surplus earnings. The RE can be used to serve many purposes depending on the company's order of priorities. A company may decide to utilize its surplus earnings in the following ways:
- Distribute it among the shareholders either in full or partial.
- Reinvest it back to the business for the purpose of expanding its operations such as purchasing a capital asset that may be used to boost production.
- Use it to pay any company's outstanding debt.
- Use it for possible merging or acquiring partnership so as to advance its business projections.
- Reinvest it in order to launch a new product to increase market variety.
- Use it to buy back shares. This is where a company repurchases the shares of stock which it had previously distributed to the public and to private investors.
How to Calculate Retained Earnings
On any company's balance sheet, retained earning is always recorded under the shareholders equity. Since it is standardized, the accumulated income is reported as a separate item in the company's balance sheet. To calculate retained earnings, you are required to add net returns to the retained earnings of the previous period. You can then deduct any net dividends rewarded to the investors.
Retained Earnings Formula
RE = (Beginning Period Retained Earnings + Net Income) / (Loss - Cash Dividends - Stock Dividends)
The calculation of retained earning is done at the end of every accounting period either quarterly or yearly. Retained earnings are highly reliant on the corresponding figure of the previous period. The outcome may be negative or positive, depending on the company's performance. A company's retained earnings can be negative if the amount it pays as dividends exceeds the net income. It can also be affected by a number of factors such as:
- Cost of goods
Retaining vs Paying the Retained Earnings
Whenever a company accumulates profits, shareholders and management will always defer when in comes to its utilization. The investors may want to be given dividends as a return for investing in the company. Most may prefer dividends payment because it comes as a tax-free income. However, the management may have a different opinion on how the net earnings should be utilized. They may want the surplus income to be retained so that it can be used to generate more returns. Note that, the decision on whether to retain or distribute the net earnings of a company is mostly left to the management. Those shareholders looking forward to more returns may support the managements decision to retain the earnings. However, those investors who are against the decisions, are given freedom to challenge it through the majority vote. However, there are different reasons why both the management and shareholders may allow the company to retain the earnings. Since the management is in a better position to understand the market and the company's business, they may have a high growth projection insight. This is a good thing for those investors who are looking forward to more higher returns. Also, both the shareholders and management may decide to pay off the high-interest debt instead of rewarding investors with dividends. Generally, to be able to reach a win-win situation, company management often go for a balanced approach. This is where the management decides to allocate a small amount to dividend while retaining a significant amount. This way, the shareholders are able to benefit from the net earnings while the company retains some to reinvest in the business.
Impact of dividends on RE
Dividends can be paid out in the form of cash or stock. Whichever payment method the company may decide to use, it reduces RE in some way. For instance, cash payment causes cash outflow and it is recorded as a net reduction in the accounts book. Cash dividends cause the company to lose liquid asset ownership. Therefore,In this process, the company's asset value in the balance sheet reduces. For stock payment, a section of the accumulated earnings is transferred to common stock. This reduces the per share evaluation which is usually reflected in the capital account meaning it does have an impact on the RE. A company that is focused on its expansion would rather not pay dividends but instead retain the earnings for used on companies activities. The cash can be used for researching, purchasing company assets, marketing, capital expenditure among other activities that can support the company's further growth. On the other hand, a company which is still growing and has a low RE may not have many choices and in most cases, it prefers distributing the dividends to respective shareholders.
How retained earnings are interpreted
Retained earnings figures, whether quarterly or yearly, do not usually give meaningful information. Also, observing the same over a long period of time may only show the trend on the amount of cash the company is retaining. Therefore,Interpretation from an investor's point of view needs to guided by how much income the retained earnings has been able to generate. You will also need to compare with other alternative investments to know whether they are performing better than the rest. To be able to assess how a company has been able to successfully utilize the retained earnings, you can look at the Retained Earnings To Market Value. This compares the change in stock price with the earnings retained by the company.
Generally, all Investors have business interest in any venture and all they care about is high returns for their investment. If retained earnings are properly utilized, it can generate more income which is a good thing for the investors. On the other hand, a company's management has practical knowledge about the market trends and expectation in terms of future opportunities in which they can utilize the surplus earnings. Therefore, their decision to retain the earnings and reinvest or make dividend payout always relies on their projection about future opportunities. However, to be able to make a decision in which both the investor and the company are guaranteed of a win, the retained earnings past performance will be used to assess the trend. Thereafter, can they then decide whether to go for the dividends payout or opt for reinvestment for long term value.