Retained Earnings

What are Retained Earnings?

Retained earnings or earnings surplus are part of the profit of an organization that is not distributed among shareholders as dividends. These are used for working capital requirements and can also be used to pay off any debt the company may have.

Retained earnings can be found on the balance sheet under the item called shareholder’s equity. Usually, companies retain the profits if there is an opportunity to earn more profits by reinvesting the profits in some other initiatives. In such cases, the companies keep the profits for investment in more profitable projects so that they can offer more returns to the shareholders of the company. Thus, the amount of retained earnings increases in the process of increasing profits.

Retained earnings of a company are calculated at the end of each financial year. A company’s dividend policy depends on the retained earnings of the company. If companies increase the amount of retained earnings, less dividend is paid to the shareholders. Similarly, when a larger amount of dividend is paid to shareholders, the amount of retained earnings goes down.

The extent of utilizing retained earnings usually depends on two factors - the industry type and how old the business is. Capital-intensive industries and start-ups require to own more assets in the future and hence they keep most of their profit as retained earnings for smoother operations. Similarly, old businesses have a significant amount of retained earnings in comparison to smaller ones because retained earnings are a part of the profit businesses earn since their inception.

Characteristics of Retained Earnings

No cost of financing

It is notable that when a company raises capital through borrowing, it has to pay a significant amount to the lenders as a part of interest. However, in the case of retained earnings, the capital is free from interest. There is no cost involved in the case of retained earnings and this is a prominent reason why businesses tend to finance their projects using retained earnings.

Less legal formalities

The utilization of retained earnings is subject to minimum legal formalities. The company only needs to pass a resolution in its annual general meeting to use these funds. Therefore, it is one of the easiest ways to use funds in terms of legal requirements.

No Floatation costs

Unlike other forms of capital use, the use of retained earnings need not use issue-related costs. There is no floatation cost involved in the utilization of retained earnings. This makes retained earnings an attractive option for organizations to fund new projects or own more assets.

No change of Control of shareholders

The use of retained earnings does not affect the existing shareholders’ control of the current company. However, in the case of other modes of issuance of shares, the control of shareholders may get changed or diluted which is not the case with retained earnings.

Advantages of Retained Earnings

• Retained earnings are a continuous source of funding for organizations. Unlike other forms of financing that require much preparation and which last only once, retained earnings can be obtained every year depending on the profits earned by the company.

• There are zero explicit costs involved in the case of retained earnings. There are no dividend, interest, and /or flotation costs involved in the case of retained earnings. This is a great advantage of retained earnings because most other forms of costs impact the financial bottom line of companies which can be avoided by the utilization of retained earnings.

• Raising funds via retained earnings offers companies more freedom and flexibility. This is so because in the case of retained earnings, using them is an internal issue that does not need the help and support of any external agent. That is also why companies tend to use as much retained earnings as possible for their future projects. The same is applicable while buying new assets.

• If the company has sudden, unexpected losses, it can bear them if it maintains a sufficient amount of retained earnings. As these funds are kept for meeting future needs, they can be used for absorbing unexpected losses as well.

• Companies that show good performance with retained earnings may get their share prices appreciated in the share markets. As good retained earnings are a sign of sound financial health, companies may use it as a pillar of success in the markets to get the share prices increased.

Disadvantages of Retained Earnings

• There may be unequal growth due to the utilization of retained earnings in the same industry. Retained earnings are internal funding sources and they do not require external sources. So, their use may lead to uneven growth.

• Retained profits are an uncertain source of funds. As retained profits are part of profits that are not distributed, it depends on the profits of the company in a certain financial year. In some cases, there may even be no retained earnings. So, a company cannot be sure to depend on retained earnings to fund its projects.

• Companies cannot rely on saving too much of retained earnings as it may cause shareholder dissatisfaction. In the case of saving retained earnings, companies withhold the dividends. However, shareholders tend to receive more dividends from the companies they invest in. So, too much of retained earnings may dissatisfy them.

• Too frequent capitalization of retained earnings may lead to overcapitalization of Reserves. Reserves may thus lead to form pressure on the entire funding process of a project for which over-retained earnings are responsible.

• In many cases, the opportunity cost of retained earnings funds can't be correctly ascertained. Therefore, companies may misappropriately use these funds. It has been observed that companies tend to use retained earrings without checking the other alternatives at hand. This may be a reason for the lack of productivity and profitability for the companies.

Factoring affecting Retained Earnings

• Dividend payouts of a company.

• Sales growth.

• Cost of goods sold.

• Net income/loss.

• Interest cost on capital to be raised.

Conclusion

Retained earnings are a very important item for the companies on their balance sheets. It not only shows how the financial health of the company but also offers the investors an idea of which projects they should invest in to get the maximum returns. That is why all company owners and investors should learn about retained earnings.

FAQs

Qns 1. What are retained earnings? Discuss in brief.

Ans. Retained earnings or earnings surplus are part of the profit of an organization that is not distributed among shareholders as dividends. These are used for working capital requirements and can also be used to pay off any debt the company may have.

Qns 2. Why do businesses tend to raise funds via retained earnings? Provide the most important reason.

Ans. Raising funds via retained earnings offers companies more freedom and flexibility. This is so because in the case of retained earnings, using them is an internal issue that does not need the help and support of any external agent.

Qns 3. Mention any three factors that affect retained earnings.

Ans.

• Dividend payouts of a company.

• Sales growth.

• Cost of goods sold.