What is the Retained Earnings Formula?
This doesn’t necessarily mean the company won’t end up paying out dividends. Rather, it refers to the fact that the complete earnings will not be disbursed as dividends.
How do you calculate retained earnings?
Retained earnings can be calculated using the retained earnings formula, as follows:
Retained earnings = retained earnings from previous period + net income - dividends
To work out a company’s retained earnings using this formula, you should understand a few key terms:
- Retained earnings from previous period — The leftover retained earnings after expenses from the previous year or time period. Companies hold retained earnings to use them for business expenses. Sometimes the complete amount will not be exhausted in a financial year.
- Net income — The revenue left over after all business expenses are met. Expenses may include the cost of goods sold, interest expenses, taxes to be paid, depreciation, and amortization. It’s the profit that is left that may be paid out as dividends to shareholders.
- Dividends — The share of the company’s profits that are dispersed to shareholders at the end of the financial year. A company can choose not to pay any dividends to the shareholders. It can also decide to pay a part of the net income or the complete net income as dividends. Cash dividends and stock dividends are the 2 major ways to pay out dividends.
Why do companies use retained earnings?
As businesses need capital to expand, they may use retained earnings to serve as capital to do so. Two methods of raising capital are available to companies: equity financing and debt financing. However, there are costs associated with raising capital using either of these methods.
This is where leveraging retained earnings is useful. Raising capital through retained earnings helps to reduce the costs associated with raising capital using equity or debt.
Using retained earnings also allows a business to reinvest its profits as the business may have a return on assets or capital. Retained earnings can also be used for process improvements that increase the company’s profit margins.
What does it mean if a company decides to retain its earnings?
If a company decides to retain its earnings, it may suggest that management believes the company’s surplus income is best utilized by reinvesting in the business.
If shareholders then choose to stand behind this decision by management, it may indicate that they have trust in the management’s ability to grow the business with a high return on capital. Growing the business in this manner may, in turn, increase shareholder value.
Another reason companies may choose to retain earnings is to take advantage of certain tax breaks. In some jurisdictions, dividends are taxed heavily, but capital gains are not. In such cases, increasing the share value by business growth or through share buyback programs may be more beneficial for shareholders.
Understanding both how to calculate the retained earnings formula and why companies may choose to use it is important for shareholders and companies alike. Retained earnings can present a number of benefits for both parties. As an investor, it is worth keeping in mind that companies that use retained earnings may be indicative of the management’s line of thinking regarding company growth.