Definition
Retained earnings, in finance, refer to the portion of a company’s net income that it retains for reinvestment back into the business or to pay off debt, rather than distributing it to shareholders as dividends. They are reported in the shareholders’ equity section of the balance sheet. The amount of retained earnings changes when a company generates profit or experiences a net loss, and when it pays out dividends.
Key Takeaways
- Retained Earnings are a portion of a company’s profit that is held or ‘retained’ back in the business rather than being paid out as dividends to shareholders. It’s essentially profit that the company reinvests for future growth instead of distributing it to shareholders.
- They represent a company’s cumulative net income or profit after paying dividends and are reinvested into the company’s core business or used to pay off debt. Therefore, it can be viewed as an indicator of a company’s financial health and growth potential.
- Lastly, although retained earnings offer reinvestment opportunities, accumulating too much without an effective strategy may suggest a lack of valuable projects in which to invest, or a reluctance to pay dividends. This may not be looked upon favorably by investors. Therefore, an optimal balance must be maintained.
Importance
Retained Earnings is a crucial finance term as it represents a company’s net earnings that have been kept or “retained” in the business after it has paid out dividends to its shareholders.
The amount of retained earnings provides a clear insight into a company’s profitability over time and its capacity to generate shareholders’ wealth without needing external financing.
Therefore, it is an important indicator for investors, creditors, and other stakeholders to assess the company’s financial health and its ability to reinvest in business operations, pay off debt, or pay dividends in the future.
In essence, a high level of retained earnings signifies a potentially lucrative investment opportunity and indicates robust financial health of the company.
Explanation
Retained Earnings, an integral part of a company’s financial health, serve as an internal source of financing that facilitates business growth and development. They are essentially the cumulative net income that a company has managed to save or ‘retain’ after paying off dividends to shareholders.
This reservoir of accumulated earnings is leveraged to reinvest in the business itself, finance acquisitions, pay off debts, or bolster the company’s overall financial position. It is a significant metric to gauge a company’s profitability over a long period.
On a balance sheet, retained earnings offer investors an insight into the company’s financial stability, indicating how much capital the firm can deploy for its growth strategies. Additionally, it serves as a cushion against economic downturns or unforeseen operational losses, safeguarding the company’s financial health.
The magnitude of retained earnings relative to dividends reflects the company’s policy on profit distribution and growth plans. An increase in retained earnings over time generally signifies that the company is profitable, growing, and efficiently managing its resources, whereas consistent declines could reveal underlying operational or financial issues.
Examples of Retained Earnings
**Apple Inc.:** As of fiscal year 2020, Apple Inc. had around $82 billion in retained earnings, an increase from $39 billion in fiscal year
This money is used by Apple for various purposes such as research and development, capital expenditure, and investments in acquisitions.**Microsoft Corporation:** The technology giant reported a staggering $6 billion in retained earnings at the end of its fiscal year in
This money represents the accumulated net income of Microsoft that has been re-invested in the business over the years, rather than paid out to shareholders in the form of dividends.**Berkshire Hathaway Inc.:** This company, led by Warren Buffet, shows another example of high retained earnings. As of the end of 2020, it had approximately $56 billion in retained earnings. Berkshire Hathaway is known for not paying dividends to its shareholders; instead, it reinvests almost all its earnings back into the business, thereby increasing its retained earnings balance significantly.
FAQs about Retained Earnings
What are Retained Earnings?
Retained Earnings refer to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Essentially, they are profits that the company has elected to reinvest in the business or hold as reserve for future use.
How are Retained Earnings calculated?
Retained Earnings are calculated by adding net income to (or subtracting any net losses from) previous term’s retained earnings and then subtracting any net dividend paid to the shareholders. The formula is: Retained Earnings = Previous Retained Earnings + Net Income – Dividends paid.
Where are Retained Earnings located in financial statements?
Retained Earnings are reported in the shareholders’ equity section of the balance sheet. However, the changes in retained earnings are prepared and reported in the statement of retained earnings, which can be attached with the balance sheet.
Why are Retained Earnings important?
Retained Earnings are important as they provide insight into a company’s net profitability after dividends. Investors use Retained Earnings to assess how much money a company is reinvesting in its business. They are a key component of shareholder’s equity and used for internal purposes to finance the business activities and for paying off the debt obligations.
Related Entrepreneurship Terms
- Balance Sheet
- Dividend Payments
- Net Income
- Earnings per Share (EPS)
- Shareholder Equity
Sources for More Information
- Investopedia: A comprehensive web resource dedicated to investing and personal finance.
- The Balance: This website offers expertly crafted content on personal finance, small business, and careers.
- Accounting Tools: It is an incredible resource for accounting guidelines, procedures, and principles.
- Fidelity Investments: An international brokerage firm providing extensive financial resources and services.
