Retained earnings definition
/What are Retained Earnings?
Retained earnings are the profits that a company has earned to date, less any dividends or other distributions paid to investors. A reasonable amount of retained earnings is needed to pay for investments in fixed assets and working capital, as well as to convince lenders that a firm is sufficiently stable to take on additional debt.
A growing company normally avoids dividend payments, so that it can use its retained earnings to fund additional growth of the business in such areas as working capital, capital expenditures, acquisitions, research and development, and marketing. It may also elect to use retained earnings to pay off debt, rather than to pay dividends. Another possibility is that retained earnings may be held in reserve in expectation of future losses, such as from the sale of a subsidiary or the expected outcome of a lawsuit.
As a company reaches maturity and its growth slows, it has less need for its retained earnings, and so is more inclined to distribute some portion of it to investors in the form of dividends. The same situation may arise if a company implements strong working capital policies to reduce its cash requirements.
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How to Calculate Retained Earnings
The formula to derive ending retained earnings is to add profits or losses to beginning retained earnings, and then subtract out any dividends paid during the period. The calculation is as follows:
Beginning retained earnings + Profits/losses - Dividends = Ending retained earnings
Accumulated Deficits
A company that has experienced more losses than gains to date, or which has distributed more dividends than it had in the retained earnings balance, will have a negative balance in the retained earnings account. If so, this negative balance is called an accumulated deficit.
Presentation of Retained Earnings
The retained earnings balance or accumulated deficit balance is reported in the stockholders' equity section of a company's balance sheet. This is typically located near the bottom of the balance sheet, as shown in the following balance sheet exhibit.
How to Evaluate Retained Earnings
When evaluating the amount of retained earnings that a company has on its balance sheet, consider the points noted below:
Age of the business. An older company will have had more time in which to compile more retained earnings. Conversely, a new one may have negative retained earnings, since it has incurred losses while building up a customer base; this is especially true for a firm that has created its own products and must expend funds for the related development work.
Dividend policy. A company that routinely issues dividends will have fewer retained earnings. Conversely, a growing business that needs to conserve cash will have more retained earnings.
Profitability. A high profit percentage eventually yields a large amount of retained earnings, subject to the two preceding points.
Cyclical industry. When a business is in an industry that is highly cyclical, management may need to build up large retained earnings reserves during the profitable part of the cycle in order to protect it during downturns. Retained earnings will then decline during downturns, as the business uses up cash to stay in business until the start of the next business cycle.
Industry with low barriers to entry. When it is easy for new competitors to enter an industry, it is more likely that existing competitors will build up significant amounts of retained earnings, which they spend down when they need to fight off competitive challenges.
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Appropriated Retained Earnings