If a company earns a lot of profit in a year, it may have enough to keep as retained earnings. The extra funds could provide that business with many options for growth and improvements. Investors, shareholders, and banks look at them too.
We will start by explaining what retained earnings are and how companies use them. Then, let’s look at the potential benefits and risks of using these funds. We will also talk about why it’s important for people outside the company as well.
Retained earnings give you an idea of a company’s overall performance. As an investor, this is valuable in finding the best stocks for your portfolio. On the other hand, business owners should know how to make the utmost use of these funds.
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What are retained earnings?
A company may have a lot of money left after a successful year. After giving dividends to shareholders, it still has so many left. That remaining amount is your retained earnings or RE.
It’s your earnings after a reporting period along with your net income or net losses minus your dividend payments. Here’s the usual retained earnings formula:
RE = Starting Period RE + Net income or losses – Stock dividends – Cash dividends.
After each accounting period, the RE ending balance will be the starting balance for the next. Since it may include losses, the RE could turn out negative.
If that’s the case, then the retained earnings may be called an accumulated deficit. If the RE is positive, then it may be referred to as accumulated gain.
As the name suggests, stock dividends mean giving a portion of company ownership. In turn, stock prices will go down. Stockholder equity doesn’t reduce its cash supply, though.
On the other hand, cash dividend payments are paid to shareholders, reducing its balance sheet. The owner doesn’t have to give up more control of the company, though.
How do companies use these funds?
Retained earnings account for the funds that a business may use for its operations. Here are the ways it could use the extra money:
- Expansion – A business may use retained earnings to build a new facility, upgrade their current ones, or hire more people.
- Mergers – It could help a company buy off other ones to spread its presence in the market. In turn, it could provide new products or services.
- Research and development – A business may spend the extra funds to create new goods and services by itself.
- More dividends – The extra money may turn into more dividends to shareholders.
- Working capital – The leftover profits may fund a company’s daily operations.
- Paying off debt – Retained earnings may reduce corporate debt. In turn, it may become more appealing to investors and lenders.
The board of directors decides how the company will use the remaining profits. It may also choose whether to pay dividends or not. However, this may not be a good idea.
If the company offers shares to the public, the companies are not required to give dividends. The shareholders may vote out the board members that decided this, though.
Are retained earnings a good way to expand a business?
A company’s RE helps it grow and improve. Here’s what’s great about using retained earnings to expand a business:
- Avoid more debt – Using RE means using money the company already made, and it wouldn’t need to borrow money. Having fewer debts can help it repay existing ones and maintain a good credit rating.
- Stay in control – If a company offers shares to others, they must have a say in business decisions. If it uses retained earnings instead, the owner doesn’t have to share control of the company.
- Decide where to spend – Investors don’t have to get in the way of spending decisions. The owner can use the money however they want.
It’s not perfect, though, and using retained earnings for expansions has its share of drawbacks too. Let’s talk more about these drawbacks:
- It takes a long time – While the company is gathering funds, they might not be spending on business opportunities. For example, releasing a product that could profit from an ongoing trend may take a while.
- No money for other purposes – RE could fund other parts of the business, not just expansion. If an owner isn’t careful, the company may lose the money it needs to run.
- Miss out on insights – Shareholders don’t always get in the way of business decisions, and the right ones can give the owner fresh ideas. In turn, the company may enter markets or offer services that the owner wouldn’t have thought of themselves.
How does it help investors?
Let’s say you want to invest in common stocks. This means looking for the ones that are likely to go up in value. This happens if a company is earning money.
So, you check their financial statements and other info. One of the important ones you should check is the statement of retained earnings.
You’ll often find it attached to the income statement because it’s a short section. Yet, this bit of info can say a lot about a company’s performance.
Retained earnings show you that it has money to spare after paying taxes, expenses, and dividends. That often means it earned quite a lot in a certain period.
Perhaps one of its products sold quite well. Or it spends less on operations. Of course, you shouldn’t just use one metric for checking a company’s health.
Why do lenders look at retained earnings?
A company may borrow money, similar to how people do. The lender also makes sure that it can pay loans back, and that’s more likely if it has extra money from RE.
Having the extra money means that the company handled its finances properly. It didn’t bury itself in debt, and it made more money. This allows the company to access financing options.
In other words, it can borrow money. Similar to RE, the funds may help in expansion. However, the money will come from outside the company, not its profits.
It has two options, debt or equity financing. The former involves an amount of cash similar to a personal loan, and the latter comes from selling shares.
The former might be better for startups. Debt can help them pay for stuff they need to operate. Later, companies can pay the loans back as they make more money.
The latter gives an existing firm more options. The sale of shares doesn’t reduce income. If needed, they could take out debts later. Owners should be careful in picking these options.
A company can have retained earnings if it does well in a given period. It may seem simple, but there’s a lot that goes into making that much money.
It is especially harder depends on market conditions. For example, COVID-19 has hit supply chains, and however, it did open new trends that companies may try to meet.
Do you want to know more? Check the other articles from Inquirer USA. They could introduce new to promising stocks and assets.
Learn more about retained earnings
What is meant by retained earnings?
It’s the amount of money a company made minus the expenses and dividends paid. Depending on how it did in a certain period, it could show a gain or loss. This may attract investors since it may show that its stock is likely to go up. What’s more, it could make it easier for the business to borrow money.
Can you use retained earnings to pay off debt?
A company may use RE to pay debts and do other things. This may include buying another company or adding more money for day-to-day operations. It may only do this if the retained earnings are positive, and otherwise, it can’t do anything with the RE.
Are retained earnings good or bad?
A company’s RE can be good or bad, depending on its value. If it’s positive, that shows that the company earned a lot of money. On the other hand, a negative RE may show that it has too much debt or gives too many dividends.