What are retained earnings?

Retained earnings meaning

Retained earnings are the total profits a company has earned over time, which haven’t been distributed to shareholders as dividends. Instead, these earnings are reinvested back into the business to fuel growth, fund future projects, and strengthen the company’s financial position.

Retained earnings play a crucial role in a business’s financial management. They represent the amount of money available for various business uses without additional debt or external financing.

How are retained earnings calculated?

Retained Earnings = Net Income – Net Loss – Dividends

Retained earnings are calculated by subtracting dividends and any net losses from the company’s net income. This value determines how much of the company’s profits it has kept and reinvested in the business rather than distributing it to shareholders.

For example, let’s say a company has a net income of $500,000 for the year. It pays out dividends of $50,000 to shareholders and reports a net loss of $20,000 from a previous year. To calculate retained earnings, you would start with the net income of $500,000 and subtract the dividends of $50,000 and the net loss of $20,000, resulting in retained earnings of $430,000.

Retained Earnings = $500,000 – $20,000 – $50,000 = $430,000

Pros & cons of retained earnings

There are several pros and cons associated with retained earnings that businesses should consider:

Pros

• Fuels growth to invest in new projects
• Safety net for unforeseen threats, such as economic downturns
• Funding flexibility

One of the main advantages of retaining earnings is that it allows businesses to reinvest in their operations and fund future growth opportunities. By retaining earnings, you can finance projects, expand product lines, or make strategic investments without seeking external financing. This can help businesses remain competitive and continue to grow over time.

Additionally, retained earnings can also provide a cushion for a business in times of economic downturn or financial difficulty. By building up a strong reserve of retained earnings, a company can better weather periods of instability or uncertainty without resorting to drastic cost-cutting measures or taking on additional debt.

Cons

• Shareholder dissatisfaction over dividends amount
• Operational inefficiencies

One potential downside is that by holding onto profits, businesses may miss out on opportunities to provide returns to shareholders. Shareholders may become impatient if they do not see a return on their investment in the form of dividends, which could lead to a decrease in share prices or shareholder dissatisfaction.

Another disadvantage of retaining earnings is that it can lead to a buildup of excess cash within a company. This excess cash may not be used efficiently or effectively and could be wasted on low-return projects or investments.

While retained earnings provide several benefits, it’s important to strike a balance between keeping earnings for future growth and rewarding shareholders. This balance depends on various factors, such the current stage of growth, industry, and investment opportunities.