What Causes Retained Earnings to Increase or Decrease?

Retained earnings, also referred to as “retained surplus”, is an accounting term defined as the portion of a company’s net income that is retained and not paid out as dividends to the stockholders. This concept is an important one for investors and analysts to understand, as it can be used to assess the performance of a company and its financial health.

In this article, the causes of increases and decreases in retained earnings will be discussed. The discussion will focus on two primary factors: dividends and stock buybacks. Both of these strategies have the potential to significantly impact a company’s retained earnings.

What is Retained Earning?

Retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments, representing the portion of profits that are not distributed to shareholders. The term ‘retained’ refers to the fact that earnings were not paid out to shareholders, but instead kept by the company.

Retained earnings decrease when a company loses money or pays dividends, but increase when new profits are made. The decision to retain earnings or distribute them among shareholders is up to company management. A growth-focused company may not pay dividends or may pay small amounts and use retained earnings for expansion activities.

Retained earnings can be used for increasing production capacity, hiring more sales representatives, launching new products, or share buybacks. Retained earnings are important in assessing a company’s financial health as it shows net income saved over time for reinvestment or distribution to shareholders.

It is clear that retained earnings can be a powerful tool for a company to grow and improve its prospects, provided that it is used in a judicious way.

How Retained Earnings Increase?

Increases in net income are often reflected in corresponding increases in retained earnings.

A company can increase its retained earnings by either increasing its net income or decreasing its dividends.

To increase net income, a company can:

• Increase revenue
• Decrease the cost of goods sold
• Decrease operating expenses
• Increase depreciation

By increasing net income, a company can increase its retained earnings and strengthen its financial health.

Similarly, a company can also reduce its dividends to increase its retained earnings. This can be beneficial when the company wants to retain more of its profits for reinvestment or other purposes.

How Retained Earning Decrease?

Operating losses and distributions to shareholders that exceed net income can lead to a decrease in retained earnings. This is because when a company experiences an operating loss, the net income of the company is reduced.

When a company pays out more in dividends than its net income for the accounting period, the amount left for retained earnings is reduced. The amount of retained earnings is a measure of the total profits that have been retained by the company since its inception.

An operating loss or distributions to shareholders that exceed net income can lead to a decrease in the amount of retained earnings. Reduced retained earnings can mean decreased profitability for a company in the future.

If a company has less retained earnings, it will have fewer resources to reinvest in its operations, such as research and development and other investments. This can lead to a decrease in the company’s competitive advantage and may have long-term effects on its ability to generate profits.

Retained earnings are an important part of a company’s financial health, and it is important for a company to manage them carefully. Companies should strive to limit the amount of operating losses and distributions to shareholders that exceed net income, in order to avoid a decrease in their retained earnings.

Dividends

Dividends are distributions of profits to shareholders from a company’s retained earnings. Generally, dividends are paid out in cash, but in some cases, it can be paid out in stock. While dividends are a way to reward shareholders, they also reduce the company’s retained earnings.

Dividends can be paid out in the following ways:

1. Regular dividends: These are paid out on a regular basis, usually quarterly or annually.
2. Special dividends: These are paid out in addition to regular dividends, and are usually a one-time payment.
3. Stock dividends: These are paid out in the form of additional shares of the company’s stock, rather than cash.

The size of a dividend is determined by the company’s board of directors, and is usually paid out as a percentage of the company’s total earnings. Companies may decide to pay out a dividend when they have excess cash, or when they need to reduce the amount of retained earnings on their balance sheet.

Dividends reduce retained earnings, since the money is no longer held in the business, but is distributed to shareholders.

Stock Buybacks

Stock buybacks are a way for companies to repurchase shares of their own stock from shareholders in order to reduce the number of outstanding shares.

This process can also be used to reduce the amount of capital that is held by the company, which in turn can lead to an increase in retained earnings.

Companies will often buy back their stock when the market price is lower than the intrinsic value of the stock, as this can help to increase the value of the remaining shares for shareholders.

It can also be used as a means to return excess capital to shareholders, as the money used for buying back the stock is not taxed as a dividend.

Stock buybacks can also reduce the amount of dividends that a company pays out to shareholders.

By repurchasing shares, the company reduces the amount of money that would otherwise be paid out as a dividend, thus resulting in an increase in retained earnings.

This can be beneficial for investors, as the company can use the additional funds to invest in future growth opportunities or to pay down debt.

When companies repurchase their own stock, it can also help to increase the share price of the company.

This is because the reduced number of outstanding shares can lead to an increase in the demand for the stock, resulting in a higher share price.

This can provide a financial benefit to the company, as the higher share price can lead to a higher market capitalization.

Conclusion

Retained earnings are an important factor in financial analysis. They can increase or decrease depending on a variety of factors, such as dividends and stock buybacks.

An increase in retained earnings is generally seen as beneficial for a company, as it can indicate a positive outlook for the future. A decrease, on the other hand, can be a sign of potential trouble.

Understanding the factors that affect retained earnings is important for any company looking to make sound financial decisions. By analyzing the reasons why retained earnings change, businesses can make informed decisions about their financial future.