Retained Earnings is all net income which has not been used to pay cash dividends to shareholders. The accounting concept is part of the balance sheet. It appears in the equity section and shows how net income has increased shareholder value.
Understanding the nuances of retained earnings helps analysts to determine if management is appropriately using its accrued profits. Additionally, it helps investors to understand if the business is capable of making regular dividend payments.
In this post we will cover retained earnings, how it is calculated, how it is used by management and some of its limitations.
What is Retained Earnings?
Retained Earnings is a term used to describe the historical profits of a business that have not been paid out in dividends. It is represented in the equity section of the Balance Sheet. It is a measure of all profits that a business has earned since its inception. But that has not been used to pay dividends to shareholders. Therefore, it can be viewed as the “left over” income held back from shareholders.
Conceptually, retained earnings simply represents any surplus of net income that has been held by the business for some future purpose. It is sometimes expressed as a percentage of total earnings, referred to as the “retention ratio”. It is important to note that the retention ratio of a business is also equal to 1 minus the dividend payout ratio.
How to Calculate Retained Earnings
The formula for calculating retained earnings is straightforward and is typically disclosed in footnotes to the financial statements. There are only three items that impact retained earnings, net income, cash dividends, and stock dividends.
It is important to note that retained earnings can be reduced by all three of these components if net income for the period is negative.
The formula is:
Beginning Period Retained Earnings = Prior Period Ending Retained Earnings
Dividends = cash and stock dividends
How Retained Earnings is Used
There are a variety of ways in which management, and analysts, view retained earnings. Management will regularly review retained earnings and make a decision based on the goals and objectives they have established.
In companies that are mature, it is common for management to make regular shareholder distributions, either in the form of cash dividends or stock dividends. These have an immediate and irreversible impact on retained earnings as distributions cannot be clawed back from shareholders once they are made.
In cases where a business is in its growth stage management might decide to use retained earnings to make investments back into the business. These types of investments can be used to fuel new product R&D, increase production capacity, or invest in sales teams.
Additionally, retained earnings is often used to finance possible mergers and acquisitions where a target business might provide some synergy or cost efficiencies.
Finally, it can be used to satisfy both long and short-term debt obligations of the business.
It is important to note that none of these uses are mutually exclusive. A growing business might decide to utilize retained earnings to finance growth while reducing debt simultaneously.
Limitations of Retained Earnings
On the surface, retained earnings as a dollar figure does not provide sufficient insight into a business. Like many financial metrics, they must be viewed over time. Even with such context this will only show us how much money is being added or taken from retained earnings. It is much more valuable for analysts to understand how the retained earnings were used and the returns associated with each use, which the figure itself cannot show.
Additionally, retained earnings must be viewed through the lens of the business’s stage of maturity. More mature businesses typically pay regular dividends whereas growing businesses should be using retained earnings to fuel growth.
Finally, if the balance of retained earnings is growing over time that might not be a good thing. Intuitively you would expect a business to be growing retained earnings as it generates profits, but investors look for businesses to payout reasonable amounts in the form of cash or stock dividends. Therefore, a growing balance might indicate little cash returns for investors and might signal that management is inefficiently utilizing retained earnings.
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