What is Retained Earnings on the Balance Sheet?
Retained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company and it is shown as the part of owner’s equity in the liability side of the balance sheet of the company.
Retained Earnings is a part of the net income or net profit retained by the Company after paying a dividend to the shareholders. It is also known as ‘retained surplus’ or ‘accumulated earnings’.
A company retains a part of its net profit earned in the financial year so as to fund future projects, invest in new businesses, acquire or take over other Companies or paying off its debt.
Components of Retained Earnings
Retained earnings can be calculated using below –
Beginning RE + Net Income (Profit or Loss) – Dividends = Ending RE
Let us look at the components of the above RE calculation formula one by one:
- Beginning RE is any accumulated surplus at the beginning of the financial year.
- An amount will be added or subtracted from the beginning RE to calculate the ending RE which will be reported at the end of the financial year.
- This amount depends on the profit or losses made by the Company and any surplus given in the form of a dividend to the shareholders.
- Net Income is Company’s total earnings in the financial year which is calculated by subtracting the expenses such as material cost, general and administration expenses, salaries of employees, depreciation, and amortization, interest to be paid on debt, and taxes from the revenue earned by the Company.
- If the revenue is more than all the expenses, the Company earns a net profit, or else the Company incurs a net loss for that particular year. Net Income is also called the bottom line of the Company and it appears on the Income Statement of the Company.
- The dividend is a portion of earnings distributed by the Company to the shareholders as a reward for their investment in the Company.
- The dividend can be in the form of cash payments or stock payments also called bonus issues. In case the Company issues bonus shares it increases the common stock amount and the paid-in capital amounts on the balance sheet.
- More the dividend paid by the Company less is the retained earnings in the balance sheet.
There is a debate on how much the Company should retain and pay the rest to shareholders and which is better – RE or Dividends? – We will get back to this later in this article.
Retained Earnings Example
Suppose the beginning RE of the Company is $ 150,000, the Company had earned a profit of $ 10,000 (Net Income) and the Board of the Company decides to pay $ 1,500 in the form of a dividend.
Now, the RE calculation at the end of the financial year will be:
RE is a part of the Shareholders’ Equity on the Balance Sheet. As can be seen below, from the Consolidated balance sheet of Colgate, RE is reported under the shareholders’ equity.
We note that it is $19.222 million and $18,861 million for 2016 and 2015, respectively.
Let us try to find Retained earnings in Balance Sheet of Colgate for 2016 using the 2015 figures.
Beginning RE (2015) = $18,861 million
Net Income of Colgate in 2016 is $2,441 million (as given below)
Dividends paid are $1380 million.
Ending RE = 18,861 + 2441 – 1380 = $19,922 million
Here, the RE is positive, denoting that the Company has experienced more profits than losses and accumulated them over the years. However, if the Company has more losses than gains, the RE is negative for such Companies and such a negative balance is called an accumulated deficit.
Retained Earnings or Dividends – Which is better?
As we have learned from above, RE and dividends are a part of the same kitty earned by the Company. If one goes up the other goes down. So, RE or dividends which is better for the investors and the shareholders? Should the Company retain a larger pie of the earnings and pay a small dividend or vice-versa?
Generally, investors think the Company which is not paying a dividend or not increasing its dividend year on year is not doing well operationally, but that may not be the case.
The Company may be retaining its earnings to invest in other projects or expanding its operations so that it could grow at a higher rate and earn better returns than the dividend paid to investors. This will, in turn, increase the share price of the Company benefitting the shareholders.
However, this case may not always be true, for cases such as:
- Management is not able to generate good returns from the RE.
- Management took a bad decision in new projects and lost a heavy chunk of it.
- The cash piles up in the books and management could not make good use of it.
- The management uses fraud accounting methods to show higher earnings.
A growing Company will avoid paying a dividend as it has to use the funds for business expansion however a mature Company would have higher outflow in dividend payments.
Thus, there is a need to strike a balance between retaining earnings and dividends to the investors so that the investors are duly rewarded for their investment and the Company has adequate funds for its needs.
Is Retained Earnings a Good Measure to Differentiate Earnings?
The amount of retained earnings in the balance sheet may not be the best measure to compare two Companies. While comparing two Companies based on the RE amount, the analyst must evaluate them on the following parameters:
- Age of the Company: A company with more time in the business will have higher RE.
- Dividend policy: A Company that pays a high and frequent dividend will have lesser RE.
- Profitability: A Company with a high-profit margin may have higher RE subject to the above two factors.
We have now got a fair idea of what is retained earnings and we have also seen the RE calculation. The management of the Company tries hard to retain a fair amount of earnings so as to meet the capital needs of the Company as well to reward the investors for their investment.
Retained Earnings Video
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