What are Retained Earnings (RE)?
Retained Earnings (RE) is the total portion of a company’s profits that are reinvested back into the business after distributing dividends to shareholders.
In good times, companies make profits. These profits trickle down to shareholders partly in the form of dividends. Yet, even after the dividends are paid, there’s usually a portion of the net income left to reinvest back into the business. These are the earnings retained by a company (aka, earnings surplus). Though retained earnings and net income are sometimes used interchangeably, they’re not the same. Net income refers to the difference between the revenue and expenses of the company over a defined period, usually within a company’s financial year. Think of retained earnings as the net income after dividends are distributed to shareholders. An entity with high retained earnings shows that it has satisfied most of its financial obligations. It can, therefore, afford to keep innovating and growing.
Suppose the fictitious Company A, had a net income of $26M in its 2018 fiscal year. Then the board decides to pay $10M in dividends to its shareholders. The retained earnings for that year would be $16M.
Retained earnings are like what you have left after paying your bills…
You could take that money and go out and buy something nice — just like a company might pay a dividend — or you could spend that money on your professional development… allowing you to earn more money in the future.
Retained earnings refer to the profits a company has earned after dividends to shareholders have been paid. It’s the net income minus any dividends paid to investors.
Retained earnings help you gain more insight into how a company has performed throughout its lifetime. Sometimes companies in their infancy may not distribute any dividends and instead use their retained earnings to fund their growth.
It’s important to consider the company’s situation. Debt at infancy often means that a company is still working to establish itself. However, if it has been operating for a long time, negative retained earnings indicate a greater cause for scrutiny.
Keep in mind that when you’re looking at retained earnings, it’s important to read them within the context of the whole balance sheet. A company that has lower retained earnings because it is paying its shareholders a higher dividend is different than a company with low retained earnings because of costly debt payments. Retained earnings are an essential part of the picture when it comes to valuing a company, but they aren’t the whole picture.
Retained earnings are recorded under the shareholder’s equity section of a corporate balance sheet. They are not an asset.
Retained earnings can be used to help the company achieve even more earnings in the future. A company could deploy this capital towards expanding business operations, such as increasing production capacity to meet market demand — say, an airline that buys new airplanes with its retained earnings or a bakery that buys a new oven. Alternatively, a company could hire more sales reps.
In some cases, retained earnings could be used to buy back shares a company has issued. A company could also deploy retained earnings as working capital to purchase property, pay off debt, hire new employees, or even to finance research and development of better products. Retained earnings are typically reinvested back into the company to help the business grow.
Dividends are usually distributed to shareholders in either cash or stock. They are subtracted from the company’s profits before calculating the retained earnings. This way, they affect the amount retained. Paying higher dividends leads to lower retained earnings and vice versa.
Companies that chose to reinvest more of their retained earnings into the business (instead of paying out large dividends) may have a competitive advantage in the marketplace against other companies that are strapped for cash. For this reason, companies typically try to seek a balance between paying dividends (and keeping investors happy) and retaining earnings.
Retained earnings, revenue, and net income differ as follows:
Shareholders are not always in favor of retaining earnings and reinvesting into the company. The bone of contention being that shareholders see dividends as a reward for investing in the business, whereas management may have other plans, in line with their strategy.
To determine whether the managers are creating more value by reinvesting profits as opposed to paying higher dividends, we compare the growth of retained earnings to market value. In this case, investors want to know the equivalent share increase for every dollar retained by management.
You can think of the market value to retained earnings metric as a way to counterbalance retained earnings. It lends context to the number you see beside retained earnings.
Retained earnings are calculated using this simple formula:
Retained Earnings (RE) = Initial RE + Net Income or Loss - Shareholder dividends
Using this retained earnings formula, you can assess how much capital a company has in hand to fund its growth.
Understanding retained earnings can be complicated, so to simplify it, let’s look at the balance sheet of a fictitious lawn care business. This simple example will show you how to find retained earnings on any balance sheet. As you look at more complicated balance sheets, just remember that retained earnings can be found under the Shareholder’s Equity heading.
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