Retained earnings, also called net assets, are the accumulated profits of a company that have not been distributed to shareholders in the form of dividends. After a company’s calendar or fiscal year ends, its income statement is issued and the net earnings (or losses) produced by the business are unveiled. The company now has two ways to allocate this earnings, they can either retain them in order to reinvest them in the business, or they can distribute them to shareholders in the form of a dividend. Retained earnings, therefore, are net earnings produced by a business, that the management have decided to reinvest as a way to finance the business with its own money.
What is Retained Earnings?
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Retained earnings are essential to grow a business. There are many ways a company can obtain financing including loans, bonds, common shares and preferred shares. Nevertheless, one of the cheapest and easiest way to fund growth is to retain the business’ earnings to reinvest them.
Commonly, businesses set aside a given portion of their earnings to pay for dividends. Yet, other businesses, as is the case of Berkshire Hathaway, the famous holding company owned by Warren Buffett, may decide to retain all the earnings produce by the business in order to finance growth.
Retaining earnings is usually a decision made by the Board of Directors, who, acting in the best interest of shareholders, determine how much of these profits should be retained and how much should be distributed. In any case, the goal of retaining is to continue to grow the business through the cheapest capital source there is.
Retained Earnings Formula
The formula to calculate the Retained Earnings (RE) for a particular time period is the following:
RE = Net Earnings * ( 1 – Dividend Payout Ratio ) or RE = Net Earnings – CD – SD
On the other hand, the formula to calculate the total retained earnings of a business at the end of a time period is this one:
RE = RE0 + Net Earnings – CD – SD
Retained Earnings Equation Components
Net Earnings: The resulting amount from subtracting all costs, expenses, taxes, interest charges, depreciation and amortization from the business revenues.
Dividend Payout Ratio: The percentage of the net income that will be distributed as dividends.
CD: The total amount of cash dividends paid during a certain time period.
SD: The total amount of stock dividends paid during a certain time period.
RE0: The total retained earnings at the beginning of the time period.
The result of any of these formula will be a certain amount of money.
Retained Earnings Example
Saturn Streetwear LLC is an apparel company that commercializes different types of bags designed in-house. The company has consistently built a solid product line with steady demand and loyal customers who really feel the brand gets what they are looking for.
This consistent growth has been possible due to a policy establish by its founders that consists in retaining 70% of the net income generated by the firm each year to reinvest it in profitable projects that push the business forward.
Last year, the company had $25,600,000 in Retained Earnings from previous years and made $7,800,000 in net income. With this information, we can calculate how much will the Retained Earnings be by the end of year, employing the formulas described above:
RE = $25,600,000 + $7,800,000 – ($7,800,000 * 30%)
RE = $31,060,000
By the end of the year, Retained Earnings were $31,060,000. On the other hand, the Retained Earnings added last year were:
RE = $7,800,000 * ( 1 – 0.3 )
RE = $5,460,000
This means the Retained Earnings account grew by $5,460,000 last year. These earnings will be reinvested in the business to keep financing its growth.
Retained Earnings Analysis
Tracking the evolution of Retained Earnings over time can help analyze the financial structure of a business. A company that retains only a small portion of its net income will eventually have to take on debt to finance growth. This, in time, has a negative impact on the company’s risk profile, as a higher leverage exposes the company to potential cash shortages if the demand for its products and services fails to meet expectations.
On the other hand, a company that retains all of its net income also has to be carefully analyzed. Refusing to distribute a portion of the earnings to shareholders has to be justified by highly satisfactory rates of return on the capital invested. Failing to deliver these returns should prompt shareholders to demand higher dividend payments, as the company is basically destroying the value of the capital it is retaining.
A balance in the distribution of the net income between dividends and retained earnings has to be found, and it usually depends on the business’ capital needs. A business that is consistently growing demands more capital and the best way to finance that growth cheaply is through retained earnings. In turn, a business that is in a downward spiral should not be retained earnings unless there’s a plausible restructuring project that involves a significant investment to turn around the situation.
Finally, in order to evaluate the profitability obtained on retained earnings, investors often evaluate the growth in the company’s net income from one period to the with the amount retained. This ratio is known as the Return on Retained Earnings (RORE).
In the example above, Saturn Streetwear has a policy of retaining 70% of its earnings. This policy has been a key of its success since the company has consistently found ways to reinvest the funds profitably. Yet, shareholders must keep track of this performance. If the management team fails to deliver these results at any given point in time, shareholders should contemplate the idea of demanding a lower retention rate.
Retained Earnings Uses, Cautions, Pitfalls
While retained earnings may be the cheapest way to finance growth in most scenarios, the aftermath of the 2008 financial crisis has made borrowed capital very cheap. This makes the opportunity to grow through borrowed increasingly attractive for business and with good reason. In this scenario, the cost of debt is lower than the cost of equity and businesses can take advantage of this situation to enter into projects that were previously not profitable due to a higher cost of capital. Only in scenarios like these the alternative of retaining a high portion of the earnings to grow a business may not be the cheapest option.