September 09, 2019

Retained Earnings Explained

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Retained Earnings Explained

Retained earnings (uncovered loss) is an organization’s final accumulated financial result for the whole time a company has been operating. They’re a significant part of the financial statements as is the balance sheet. This article will cover retained earnings, how to calculate them and why they’re important. You’ll also find out why owners and investors need to keep an eye on changes in retained earnings. 

What are Retained Earnings?

The retained earnings (loss) of the reporting year allows you to assess your company’s financial viability. They’re the undistributed part of the profit in the company’s balance after payments have been made except for dividends and business development. Retained earnings are part of the shareholder’s equity in your company. Board members have the privilege of deciding how and when to distribute profits or not. You’ll record this formally in the company’s minutes. 

You’ll find retained earnings in the shareholder’s equity section of the balance sheet. Retained earnings could sometimes be the same as net profit. This happens if the company didn’t accrue dividends in the reporting year and lacks deferred tax liabilities. 

An important distinction, though, is that retained earnings result from the company’s work for the whole period it’s been in operation and the reporting year. Net profit, however, is just what the company made in the current reporting period. 

What are retained earnings, then?

Retained earnings serve as an internal source of long-term financing. Your goal as a company owner is to ensure you accumulate these funds. Company owners use retained earnings to create a reserve fund for future business development to pay dividends and to pay off debts.

To ensure you place some of your company’s income in a reserve, you’ll need it to:

  • Pay for unexpected expenses 
  • Fund research and development
  • Invest in better equipment or
  • Train or hire skilled employees, etc.

Without retained earnings your company will struggle to grow or attract investors.

But, balance this with a need to also use retained earnings to pay dividends. Shareholders and investors will lose interest in your company if you only use profits for a company’s internal needs.

Calculation

Here’s what you take into account when calculating your retained earnings (uncovered loss):

  • Its value at the start of the fiscal year
  • The net income (or loss) for the year, and
  • The amount of dividends paid to owners (for Joint Stock Companies (JSCs), which are payments to shareholders; for LLCs, payments to founders).

The result of your calculation will be recorded in the equity section of the balance sheet as well as in the statement of retained earnings.

Depending on the final result for the company’s activity, retained earnings formula you use will vary:

If showing profit, follow RE = RE 0 + NI – 3. The ‘RE’ and ‘RE 0’ show the retained earnings at the start and end of the period. NI is net income, and D is the payment to owners. If there’s a loss in the reporting year, you’ll adjust the retained earnings formula to this: RE = RE 0 – L – D. ‘L’ is the loss for the current year.

What affects retained earnings?

Retained Earnings Explained

Keep in mind the retained earnings may differ in different reporting periods. Here’s what might influence it:

  • The amount of dividends paid to the company owners
  • A change in the net profit
  • The value of commodity assets increasing or decreasing
  • A change in overhead costs
  • Tax rates changes, and
  • Changes in the company’s business strategy.

Wise Distribution of Profits

Retained Earnings Explained

Only an organization’s owners or shareholders can decide how to distribute the amount of accumulated profit. Shareholders’ decisions and the respective instructions about accounting are recorded in the minutes of the general meeting.

What are retained earnings used for?

  1. Reserve funds. The law requires some businesses to create a reserve fund with net profit, while others have a choice. Reserve funds are used to cover losses and buybacks of public shares as well as to cover liabilities. Think of the reserve fund as a financial security ‘blanket’ of the organization.
    Use these funds for essential, unforeseen expenses such as to replace failed equipment or components. Set aside part of the reserve for the scheduled update of assets as well as to launch new activities.

Owners can pay dividends with the profit left after creating the reserve fund. This is what companies usually do, but note when you accrue dividends, your retained earnings shrink. That means when you pay dividends you’re reducing the company’s assets.

Retained earnings analysis

When analyzing your retained earnings, you should assess the change in its share of the equity amount. Decreased retained earnings show a decline in the company’s business activity. However, before concluding that, look at the structure of equity capital. Also take into account the company’s adopted accounting policy, as it will determine the size of the retained earnings. Consider, too, there may have been errors that led to overstating income and therefore reduced retained earnings.

However, if retained earnings increased, it suggests:

  • Accumulation (but only if they’re not invested in projects or used to stimulate investors’ interest. In that case, the company could suffer for it down the road. It’s income could be cut due to manufacturing goods not being as competitive, equipment depreciating, loss of attractiveness, etc.)
  • Errors in reports that increase costs, or
  • Unclaimed dividends more than six years old.

Investors have a keen eye for companies that invest funds that remain after paying dividends into its development. That’s a sure sign the company will improve, expand over time and deliver larger shareholder dividends in the future. Shareholders are betting on this when they reinvest their bonus monies back into the company in the hopes of receiving more substantial returns.

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Author: Charles Lutwidge

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