UNDERSTANDING
RETAINED EARNINGS

Retained earnings, an important accounting concept, reveals useful information about a company’s current financial state. Discover what this information can tell investors, and why it is useful to know.

Retained earnings can be a strong signal to investors. That is, every investor should know about the value of retained earnings and how to calculate them because they can be a good indicator of profitability and prudent management.

This guide will look at what retained earnings are, what they reveal, and how to calculate them. It will also explain the relationship between retained earnings and dividends. So, dive in to find out how understanding more about retained earnings can help you to become a better-informed investor.  

What are retained earnings?

Retained earnings are the funds left over after all expenses and distributions to shareholders have been deducted from a company’s total earnings. These earnings are referred to as being “retained” as they are held by the company instead of being distributed among shareholders as dividends.

What do companies use retained earnings for?

Companies may use their retained earnings in a variety of ways. Some of the strategies businesses may choose when using these funds include:

• Reserving cash for a rainy day
• Paying down debt
• Buying back company shares
• Growing the business
• Investing, such as acquiring other businesses, property, stocks, bonds, etc.

What do retained earnings reveal?

Essentially, retained earnings reveal a company’s underlying profitability as well as its prudent fiscal management. For example, there is little point in paying out all of your retained earnings to shareholders if it means limiting opportunities for growth or acquisition.

“The average return on retained earnings or capital over the last 12 months is about 14% among companies in the S&P 500.”

Forbes

This is more than many investors can earn elsewhere, so it makes sense for the best-managed companies to deploy the retained earnings on behalf of shareholders to grow the business.

The well-known investor, Warren Buffett, examines how well management uses retained earnings when he evaluates companies.

Why should you explore retained earnings as an investor?

An investor can compare retained earnings statements over time to gauge and manage the company’s level of risk. Healthy and consistent retained earnings suggest a less risky investment.

If you are thinking of adding cyclical stocks to your investment portfolio, you will want to know if the business retains enough earnings to tide it over through any future downturns.

How to calculate retained earnings

This is the basic formula for calculating retained earnings:

Period Start Retained Earnings + Net Income (or – Net Loss) – Cash Dividend – Stock Dividend = New Retained Earnings Balance.

Here is an example for company XYZ:

• At the period start, retained earnings were $5,000
• Annual net profit was $10,000
• The annual dividend policy is 20% of profit, so company dividend will be $2,000
• New retained earnings = $13,000

This is what the calculation will look like: 

Period Start Retained Earnings $5,000 + Profit $10,000 – Dividends $2,000 = Period End Retained Earnings $13,000.

Retained earnings vs dividends

As mentioned above, retained earnings are the funds remaining after any dividends have been paid, and all costs have been deducted from revenue.

Each company will have a unique dividend policy decided by its board and managed according to actual financial results, profit and losses.

A booming tech company may choose not to pay dividends because it believes it can make better use of the retained earnings to grow the business. Patient shareholders will benefit as the share price rises. On the other hand, a mature company with limited growth prospects may choose to pay out regular dividends and minimise retained earnings.

Negative retained earnings can put a company in a riskier position; however, companies in their early stage, such as newly IPO’d start-ups, may show losses and use debt to support their initial growth. During this growth phase, losses will be incurred, and retained earnings will be negative. However, if the company model and investments achieve the goals set by management, there may be net profits, and positive retained earnings may be recorded.

Think about your personal needs and investment goals before you choose to buy stocks in a company that regularly distributes retained earnings. Do you want regular dividends now, or would you rather a business put retained earnings towards growing the company?

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FAQs

Are retained earnings a debit or credit?

Retained earnings are a credit on the balance sheet, located under the equity section.

Are retained earnings an asset?

In accounting terms, retained earnings belong to shareholders, so they are not an asset to the company.

Can retained earnings be negative?

Yes. When a company’s expenses, plus dividends, are greater than its earnings, it will have negative retained earnings.