Retained earnings is a crucial concept that investors should thoroughly understand to help them make better investment decisions. They offer important insight into a company’s financial health. With that said, here is retained earnings explained for smart investing.
Rather than distributed as shareholder dividends, retained earnings (RE) are the portion of company profits reserved for company reinvestment.
Such reinvestment is commonly in the form of fixed asset purchases and working capital, as well as clearing debts. It can also include research and development and other growth-generating efforts.
In terms of how to calculate retained earnings, the formula is:
RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends
where
RE = Retained Earnings
In terms of formula components, “beginning period” refers to the previous year’s retained earnings.
“Net income” is the accounting profit a company has remaining after clearing all its expenses. Meanwhile, “dividends,” whether in cash or in stocks, are shareholders’ cut of business profits.
A retained earnings example:
A company has a beginning RE of $77,232 and an ending one of $78,732. Its net income is $5,297. Thus, $77,232 – $78,732 + $5,297 = $3,797. The latter figure is the amount of dividends paid.
To calculate retained earnings: $77,232 + $5,297 – $3,797 = $78,732 in retained earnings.
Typically, retained earnings are listed on a company’s balance sheet following each accounting period in the shareholders’ equity section.
An example: After being reported on the balance sheet, the figure becomes a part of a business’s overall book value.
Also, movements in a company’s equity balances, including RE, are recorded on statement of changes in equity. For publicly traded companies, this supplemental statement is required.
Retained earnings represent a key variable for gauging a company’s financial health. A business can use it to see the net income it has saved over time. With that information, the company can decide to either reinvest or distribute to shareholders.
Note that high retained earnings can indicate consistent profitability and business reinvestment. However, it can also suggest ineffective profit reinvestment or insufficient shareholder returns. Low retained earnings likely means a business has experienced previous-year net income losses. This state could signal poor financial health.
Further, “negative retained earnings” commonly indicates that the current period’s net loss exceeds the retained earnings’ beginning balance.
Retained earnings, as an indicator of company health, can impact investment decisions. Note, though, that while the figure shows a company’s past earnings, there are no guarantees regarding future performance. Nor are there guarantees of optimal reinvesting.
Thus, it may be better for investors to focus on a business’s long-term return on assets, return on invested capital, and growing cash flows and per-share earnings. That data can clarify how well the company has allocated retained earnings.
If a company is focused on growth and expansion, it may just pay small dividends, if at all. Why? Because it would rather employ retained earnings to fund R&D, working capital requirements, or marketing efforts. To achieve more growth, the company may also use retained earnings to finance capital expenditures and acquisitions.
Still, companies must carefully consider how they balance dividends distribution and retained earnings. Low dividend payouts allow the company to grow. Such growth can result in more profits. In turn, that can lead to higher investor dividend payouts. However, lower dividends can also reduce the company’s stock price since they can signal a weakened financial position.
Dividends are usually paid from a company’s earnings. Thus, if earnings drop over time, the company must decide to either heighten its payout or find capital elsewhere.
A dividend payout ratio refers to the percentage of earnings a company paid to shareholders through dividends. Say a 25% dividend payout ratio shows that Company X is paying a quarter of its net income to shareholders. The net income balance – 75% — that the company keeps for growth is retained earnings.
Dividend payouts vary depending on the industry. Therefore, the ratio is commonly used to make industry-wide comparisons. For example, real estate investment trusts (REITs) have tax favorability. Because of that, they must distribute at least 90% of earnings to shareholders.
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It is important for investors to fully understand retained earnings, and how to analyze them, before investing in a company. Despite their limitations, such earnings represent the reinvestment of profits and are a key indicator of a company’s financial health.
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