The retained earnings are the net earnings accumulated to date, or the earnings obtained by a company after accounting for the payment of dividends to shareholders.
It is also called a profit surplus. Represents the reserve money that is available for the administration of the company, to be reinvested in the business.
This amount is adjusted whenever there is an entry in the accounting records that affects an income or expense account. A large retained earnings balance means a financially healthy organization.
A company that has experienced more losses than gains to date, or that has distributed more dividends than it had in the retained earnings balance, will have a negative balance in the retained earnings account. If so, this negative balance is called the accumulated deficit..
The balance of retained earnings or accumulated deficit balance is reported in the stockholders' equity section of a company's balance sheet..
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A company generates profits that can be positive (gains) or negative (losses).
The following options broadly cover all the possibilities on how the earned earnings can be used:
- Distribute totally or partially among the shareholders of the company in the form of dividends.
- Invest to expand business operations, such as increasing production capacity or hiring more sales representatives.
- Invest to launch a new product or variant. For example, the refrigerator manufacturer seeks to produce air conditioners. On the other hand, the chocolate cookie manufacturer launches orange or pineapple flavored variants.
- Be used for any potential merger, acquisition, or partnership that leads to better business prospects.
- Repurchase of shares.
- They can be held in reserve pending future losses, such as the sale of a subsidiary or the expected outcome of a lawsuit..
- Pay any outstanding debt the business may have.
The first option leads to the profit money leaving the company accounts forever, because the dividend payments are irreversible..
All other options immobilize the money from the earnings for use within the business. Said investments and financing activities constitute retained earnings..
When a company generates surplus income, part of the shareholders can expect some income in the form of dividends. This is as a reward for placing your money in the company.
Traders looking for short-term profits may also prefer to receive dividend payments, which offer instant profits. On the other hand, company management may think that the money could be better used if it is held within the company..
Both management and shareholders may like the company to retain profits for different reasons:
- By being better informed about the market and the company's businesses, management can have a high-growth project envisioned, which they perceive as a candidate to generate substantial returns in the future..
- In the long term, such initiatives can lead to better returns for the company's shareholders, rather than those obtained from dividend payments..
- It is preferable to pay a debt with high interest, instead of paying dividends.
Frequently, the management of the company decides to pay a nominal amount of dividends and retain a good part of the profits. This decision provides a benefit for all.
Dividends can be distributed in cash or shares. Both forms of distribution reduce retained earnings.
As the company loses ownership of its liquid assets in the form of cash dividends, it reduces the value of the company's assets on the balance sheet, affecting retained earnings..
On the other hand, although the stock dividend does not lead to a cash outflow, the stock payment transfers a portion of the retained earnings to the common stock..
Retained earnings are calculated by adding net earnings (or subtracting net losses) from the prior period's retained earnings, and then subtracting any dividends paid to shareholders. Mathematically the formula would be:
Retained earnings = Retained earnings at the beginning of the period + Net profit (or loss) - Cash dividends - Stock dividends.
The amount is calculated at the end of each accounting period (quarterly / annually). As the formula suggests, retained earnings depend on the corresponding figure from the previous term.
The resulting number can be positive or negative, depending on the net profit or loss generated by the company.
Alternatively, the company that pays a large amount of dividends, which exceed the other figures, can also lead to retained earnings turning negative..
Any item that affects net profit (or loss) will affect retained earnings. Among these elements are: sales income, cost of merchandise sold, depreciation and operating expenses..
One way to evaluate the success of a company using retained earnings is through a key indicator called "retained earnings at market value.".
It is calculated for a period of time, evaluating the change in the price of the shares with respect to the earnings retained by the company.
For example, over a five-year period, between September 2012 and September 2017, Apple's stock price increased from $ 95.30 to $ 154.12 per share..
During that same five-year period, the total earnings per share was $ 38.87, while the total dividend paid by the company was $ 10 per share..
These figures are available in the "key indicators" section of the company reports..
The difference between earnings per share and the total dividend gives the net earnings retained by the company: $ 38.87 - $ 10 = $ 28.87. That is, during this five-year period, the company had retained earnings of $ 28.87 per share..
During that same time, the price of its shares increased by $ 154.12 - $ 95.30 = $ 58.82 per share.
Dividing this increase in price per share by retained earnings per share gives the factor: $ 58.82 / $ 28.87 = 2.04.
This factor indicates that for every dollar of retained earnings, the company managed to create a market value of $ 2.04.
If the company had not withheld this money and had requested a loan with interest, the value generated would have been less, due to the payment of interest..
Retained earnings offer free capital to finance projects. This enables efficient value creation by profitable companies.
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