Retained Earnings

 

What Are Retained Earnings?

Retained earnings are an important concept in accounting. The term refers to the historical profits earned by a company, minus any dividends it paid in the past. The word "retained" captures the fact that because those earnings were not paid out to shareholders as dividends they were instead retained by the company. For this reason, retained earnings decrease when a company either loses money or pays dividends, and increase when new profits are created.

Note: 

• Retained earnings (RE) is the amount of net income left over for the business after it has paid out dividends to its shareholders.
• The decision to retain the earnings or distribute them among the shareholders is usually left to the company management.
• A growth-focused company may not pay dividends at all or pay very small amounts because it may prefer to use the retained earnings to finance expansion activities.

Retained Earnings Formula and Calculation

$\begin{aligned} &\text{RE} = \text{BP} + \text{Net Income (or Loss)} - \text{C} - \text{S} \\ &\textbf{where:}\\ &\text{BP} = \text{Beginning Period RE} \\ &\text{C} = \text{Cash dividends} \\ &\text{S} = \text{Stock dividends} \\ \end{aligned}$

What Retained Earnings Can Tell You

The following options broadly cover all possible uses a company can make of its surplus money. The first option leads to the earnings money going out of the books and accounts of the business forever because dividend payments are irreversible.

All the other options retain the earnings for use within the business, and such investments and funding activities constitute the retained earnings (RE).

• The income money can be distributed (fully or partially) among the business owners (shareholders) in the form of dividends.
• It can be invested to expand the existing business operations, like increasing the production capacity of the existing products or hiring more sales representatives.
• It can be invested to launch a new product/variant, like a refrigerator maker foraying into producing air conditioners, or a chocolate cookie manufacturer launching orange- or pineapple-flavored variants.
• The money can be used for any possible merger, acquisition, or partnership that leads to improved business prospects.
• It can also be used for share buybacks.
• The earnings can be used to repay any outstanding loan (debt) the business may owe.

By definition, retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. It is also called earnings surplus and represents the reserve money, which is available to the company management for reinvesting back into the business. When expressed as a percentage of total earnings, it is also called the retention ratio and is equal to (1 – the dividend payout ratio).

Though the last option of debt repayment also leads to the money going out of the business, it still has an impact on the business's accounts (for example, on saving future interest payments, which qualifies it for inclusion in retained earnings).

Profits give a lot of room to the business owner(s) or the company management to use the surplus money earned. This profit is often paid out to shareholders, but it can also be reinvested back into the company for growth purposes. The money not paid to shareholders counts as retained earnings.

Management and Retained Earnings

The decision to retain the earnings or to distribute them among shareholders is usually left to the company management. However, it can be challenged by the shareholders through a majority vote because they are the real owners of the company.

Management and shareholders may want the company to retain the earnings for several different reasons. Being better informed about the market and the company’s business, the management may have a high-growth project in view, which they may perceive as a candidate for generating substantial returns in the future.

In the long run, such initiatives may lead to better returns for the company shareholders instead of those gained from dividend payouts. Paying off high-interest debt may also be preferred by both management and shareholders, instead of dividend payments.

On the other hand, when a company generates surplus income, a portion of the long-term shareholders may expect some regular income in the form of dividends as a reward for putting their money in the company. Traders who look for short-term gains may also prefer dividend payments that offer instant gains.

Most often, the company's management takes a balanced approach. It involves paying out a nominal amount of dividends and retaining a good portion of the earnings, which offers a win-win.

Dividends vs. Retained Earnings

Dividends can be distributed in the form of cash or stock. Both forms of distribution reduce retained earnings. Cash payment of dividends leads to cash outflow and is recorded in the books and accounts as net reductions. As the company loses ownership of its liquid assets in the form of cash dividends, it reduces the company’s asset value in the balance sheet, thereby impacting RE.

On the other hand, though stock dividends do not lead to a cash outflow, the stock payment transfers part of the retained earnings to common stock. For instance, if a company pays one share as a dividend for each share held by the investors, the price per share will reduce to half because the number of shares will essentially double. Because the company has not created any real value simply by announcing a stock dividend, the per-share market price is adjusted according to the proportion of the stock dividend.

Though the increase in the number of shares may not impact the company’s balance sheet because the market price is automatically adjusted, it decreases the per-share valuation, which is reflected in capital accounts, thereby impacting the RE.

A growth-focused company may not pay dividends at all or pay very small amounts because it may prefer to use the retained earnings to finance activities such as research and development, marketing, working capital requirements, capital expenditures, and acquisitions to achieve additional growth. Such companies have high retained earnings over the years.

A maturing company may not have many options or high-return projects for which to use the surplus cash, and it may prefer handing out dividends. Such companies tend to have low RE.

Retained Earnings vs. Revenue

Both revenue and retained earnings are important in evaluating a company's financial health, but they highlight different aspects of the financial picture. Revenue sits at the top of the income statement and is often referred to as the top-line number when describing a company's financial performance.

Revenue is the money generated by a company during a period but before operating expenses and overhead costs are deducted. In some industries, revenue is called gross sales because the gross figure is calculated before any deductions.

Retained earnings are the portion of a company's cumulative profit that is held or retained and saved for future use. Retained earnings could be used for funding an expansion or paying dividends to shareholders at a later date. Retained earnings are related to net (as opposed to gross) income because it's the net income amount saved by a company over time.

Limitations of Retained Earnings

For an analyst, the absolute figure of retained earnings during a particular quarter or year may not provide any meaningful insight. Observing it over a period of time (for example, over five years) only indicates the trend of how much money a company is adding to retained earnings.

As an investor, one would like to know much more—such as the returns the retained earnings have generated and if they were better than any alternative investments. Additionally, investors may prefer to see larger dividends rather than significant annual increases to retained earnings.

Retained Earnings-to-Market Value

One way to assess how successful a company was in using the retained money is to look at a key factor called retained earnings to market value. It is calculated over a period of time (usually a couple of years) and assesses the change in stock price against the net earnings retained by the company.

For example, during the period between September 2016 and September 2020, Apple Inc.'s (AAPL) stock price rose from $28.18 to $112.28 per share.1 During the same period, the total earnings per share (EPS) was $13.61, while the total dividend paid out by the company was $3.38 per share.

As Morningstar indicates, Apple had the following EPS and dividend figures over the given time frame, and summing them up gives the above values for total EPS and total dividend.

The difference between total EPS and total dividend gives the net earnings retained by the company: $13.61 - $3.38 = $10.23. That is, over the period, the company retained a total of $10.23 earnings per share.

Over the same duration, its stock price rose by ($112.28 - $28.18 = $84.10) per share. Dividing this price rise per share by net earnings retained per share gives a factor of ($84.10 / $10.23 = 8.22), which indicates that for each dollar of retained earnings, the company managed to create $8.22 worth of market value.

If the company had not retained this money and instead taken an interest-bearing loan, the value generated would have been less due to the outgoing interest payment. RE offers free capital to finance projects, allowing for efficient value creation by profitable companies. However, readers should note that the above calculation is indicative of the value created with respect to the use of retained earnings only, and it does not indicate the overall value created by the company.

Example of Retained Earnings

Companies publicly record retained earnings under the shareholders' equity section on the balance sheet. For instance, Apple Inc.’s balance sheet from fiscal Q3 of 2019 shows that the company had retained earnings of $53.724 billion as of the end of the quarter in June 2019:2

Similarly, the iPhone maker, whose fiscal year ends in September, had $70.4 billion in retained earnings as of September 2018:2

The retained earnings are calculated by adding net income to (or subtracting net losses from) the previous term’s retained earnings and then subtracting any net dividend(s) paid to the shareholders.

The figure is calculated at the end of each accounting period (monthly/quarterly/annually). As the formula suggests, retained earnings are dependent on the corresponding figure of the previous term. The resultant number may either be positive or negative, depending upon the net income or loss generated by the company over time. Alternatively, the company paying large dividends that exceed the other figures can also lead to the retained earnings going negative. 

Any item that impacts net income (or net loss) will impact the retained earnings. Such items include sales revenue, cost of goods sold (COGS), depreciation, and necessary operating expenses.

Are retained earnings a type of equity?

Retained earnings are a type of equity and are therefore reported in the shareholders’ equity section of the balance sheet. Although retained earnings are not themselves an asset, they can be used to purchase assets such as inventory, equipment, or other investments. Therefore, a company with a large retained earnings balance may be well-positioned to purchase new assets in the future or offer increased dividend payments to its shareholders.

What does negative retained earnings mean?

Generally speaking, a company with a negative retained earnings balance would signal weakness because it indicates that the company has experienced losses in one or more previous years. However, it is more difficult to interpret a company with high retained earnings.

What does it mean for a company to have high retained earnings?

On one hand, high retained earnings could indicate financial strength since it demonstrates a track record of profitability in previous years. On the other, it could also indicate that the company’s management is struggling to find profitable investment opportunities for its retained earnings. Under those circumstances, shareholders might prefer it if management simply paid out its retained earnings balance as dividends.

(Article source from: https://www.investopedia.com/terms/r/retainedearnings.asp)

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