What is Retained Earning?

Retained earnings, also known as accumulated earnings, refer to the amount of net income and profits that a business has kept since it initially commenced operation. It is the portion of a company’s profit that is not paid out as dividends to shareholders, but instead retained in order to finance operations and/or reinvest into the company’s future growth opportunities.

In terms of accounting, these earnings are listed on the balance sheet under stockholders’ equity. Retained earnings can be used to purchase capital assets such as new buildings, invest in research and development projects, or contribute towards expansion efforts. Additionally, companies may choose to retain this income to provide working capital for day-to-day operations and other financial pressures associated with running a business.

Debt financing involves the borrowing of funds that must be repaid in the future, while equity finance is acquired by selling a portion of the company, which can lead to a dilution of control over the business. Both of these sources are considered external forms of financing.

Retained earnings are an internal source of finance whereby the profit earned by a business in previous years are used for current operations or expansion purposes. This is the most cost-effective way to obtain financing as no repayment is required (unlike debt financing) and control will not be diluted (as opposed to external equity financing).

For these reasons, retained earnings can be seen as the best option when it comes to financial decision-making. This idea has been discussed in great detail in the context of the Pecking Order Theory.

How to calculate Retained Earning

Calculating retained earnings is an important part of understanding the financial health of a company. Retained earnings represent the portion of a company’s net income that is kept in reserve, rather than being distributed to shareholders in the form of dividends. To calculate retained earnings, you need to start with the company’s net income and then subtract any dividends paid out to shareholders.

Here are the steps to calculate retained earnings:

Determine the company’s net income: The first step in calculating retained earnings is to determine the company’s net income. This is done by subtracting the company’s total expenses from its total revenues for a given period.
Subtract dividends paid to shareholders: Once you have the company’s net income, you need to subtract any dividends paid to shareholders during the same period. This includes any regular dividends, as well as any special dividends.
Add or subtract changes in reserves: Depending on the company, there may be other changes in reserves during the period that need to be taken into account. For example, if the company has increased its reserves, this amount should be added to the net income. If the company has reduced its reserves, this amount should be subtracted.
Calculate the final retained earnings figure: After you have subtracted dividends paid to shareholders and taken into account any changes in reserves, you can calculate the final retained earnings figure. If the company has beginning retained earnings, we need to total both balances to arrive at the ending retained earning figure.

Classification of Retained Earning

The Equity section of a Balance Sheet includes the Retained Earnings, which are typically at the bottom of the list. These earnings can change depending on whether there is a profit or loss in that accounting period, as profits raise the retained earnings while losses reduce them. It is also important to remember that any profit or loss stated in the Income Statement will be reflected in Retained Earnings as it is recorded there. So, when there is a profit, the retained earnings will increase; but if there is a loss, the amount will decrease.

It is essential to bear in mind that retained earnings can transform into accumulated losses if a company has experienced more deficits than gains over time. If a company has sustained losses for an extended period, its retained earnings can quickly be depleted and accumulate into overall losses.

Further, the business’s dividend payment is subtracted from its retained earnings. The retained earnings are the profit the business has accumulated over time and, hence, represent an important component of the company’s financial position. While the dividends paid out to shareholders reduce the retained earnings figure on paper, it is important to note that by paying out their due dividends, businesses are rewarding their shareholders and showing that they have faith in their own future prospects.

Important of Retained Earning

Capital accumulation: Retained earnings provide a way for a company to accumulate capital over time without the need to issue additional stock or take on debt. This helps a business to maintain financial stability and independence.
Investment opportunities: Retained earnings can be used to invest in new projects or initiatives, allowing a business to grow and expand. This can help to generate additional revenue and improve overall financial performance.
Dividend payments: Retained earnings can be distributed as dividends to shareholders, which can be an attractive investment opportunity for those looking for a steady stream of income. This can also help to increase the stock price and overall market value of a company.
Improved financial ratios: By retaining earnings, a company can improve its financial ratios, such as the debt-to-equity ratio and return on equity. This can help to attract investors and improve the overall financial health of a business.
Emergency funds: Retained earnings can be used as an emergency fund, helping a business to weather financial downturns or unexpected events. This can provide a safety net and help to ensure the long-term stability and success of a company.

Conclusion

Retained earnings are a useful source of finance for businesses because they are cost-effective and there is no dilution of control. They can also provide the company with greater financial flexibility. As such, companies should consider leveraging this financing source when planning their future strategic objectives.

Retained earnings are the portion of a business’s profits that are not distributed to its shareholders but rather retained by the company for use in operations. This amount is located on the equity section of the balance sheet. When a business earns a profit, the amount is recorded as an increase in retained earnings; similarly, when a business incurs a loss, this causes a decrease in retained earnings. If losses continue to accumulate, it can potentially lead to an accumulated loss being recorded on the balance sheet instead of retained earnings.