Retained earnings is all net income that has not been used to pay cash dividends to shareholders. This 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 determine whether management appropriately uses its accrued profits. Additionally, it helps investors determine whether the business can make regular dividend payments.

This post will cover retained earnings, how they are calculated, how management uses them, and some limitations.

What is Retained Earnings?

Retained earnings is a term used to describe a business’s historical profits that have not been paid out in dividends. They are represented in the equity section of the balance sheet. 

Retained earnings measure all profits a business has earned since its inception but that haven’t been used to pay dividends to shareholders. Therefore, they can be viewed as the “leftover” income held back from shareholders.

Conceptually, retained earnings represent any surplus of net income the business has held for future purposes. It is sometimes expressed as a percentage of total earnings, referred to as the “retention ratio.” 

Retention Ratio = (Net Income – Dividends Distributed) / Net Income

How to Calculate Retained Earnings

The formula for calculating retained earnings is straightforward and typically disclosed in the financial statements’ footnotes. 

Dividends and income impact retained earnings, but often in different ways.

The formula is:

Retained Earnings = Beginning Retained Earnings + Net Income − Dividends

Explanation of Terms:

  • Beginning Retained Earnings: This is the retained earnings balance at the beginning of the accounting period. It demonstrates the cumulative profits reinvested in the company from previous years.
  • Net Income: This is a company’s profit during the current period. It is calculated by subtracting total expenses from total revenues. Net income increases retained earnings because it represents profit the business can retain instead of being distributed as dividends.
  • Dividends: The company pays dividends to shareholders, which reduces retained earnings since dividends represent a payout of profit rather than an investment back into the company.

How Retained Earnings is Used

Management and analysts view retained earnings in various ways. Management regularly reviews retained earnings and decides based on established goals and objectives.

In mature companies, management often makes regular shareholder distributions, either cash or stock dividends. 

These have an immediate and irreversible impact on retained earnings, as distributions cannot be clawed back from shareholders once made.

In cases where a business is in its growth stage, management might decide to use retained earnings to invest back into the business. 

These types of investments can: 

  • Fuel new product R&D
  • Increase production capacity
  • Boost sales teams

Retained earnings often finance possible mergers and acquisitions where a target business might provide synergy or cost efficiencies.

Finally, it can satisfy the business’s long and short-term debt obligations.

It is important to note that none of these uses are mutually exclusive. A growing business might use retained earnings to finance growth while also reducing debt.

Limitations of Retained Earnings

On the surface, retained earnings does not provide sufficient insight into a business as a dollar figure. Like many financial metrics, it must be viewed over time. 

Even with context, this figure will only show how much money is 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 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 use retained earnings to fuel growth.

Monitor if the balance of retained earnings grows over time—this might not be a good thing. 

Intuitively, you would expect a business to grow retained earnings as it generates profits. Still, investors look for businesses to pay out reasonable cash or stock dividends. 

Therefore, a growing balance might indicate little cash returns for investors and signal that management is inefficiently utilizing retained earnings.

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