What are Retained Earnings?
Retained earnings are the monies a company has left over after paying dividends to its shareholders. It is an important tool that shows you how much money a company has to spend on other aspects of its business. With the dividends paid, a company can use the retained earnings to expand business operations, fund a merger or acquisition, buy back some of its stock, or repay some of its debts.
Investors and accountants calculate retained earnings to see how companies spend their money and how much of their profits are going to shareholders.
Learn more about retained earnings and how it’s calculated.
What Are Retained Earnings?
Publicly traded companies pay their shareholders in the form of dividends at the end of every quarter once they announce their earnings. A company’s management typically decides what portion of its earnings will go to its shareholders. Whatever is left over qualifies as retained earnings. A company can use this leftover money for other purposes.
Retained earnings can be calculated at the end of every month, quarter, or year. They can be positive or negative depending on whether a company made a profit. A company may also have negative retained earnings if it pays its shareholders more than it spends on other aspects of the business.
Retained earnings aren’t the same as revenue. Revenue is the company’s total earnings over a set period of time before overhead and operating expenses are deducted. Retained earnings make up a portion of a company’s total earnings.
Retained earnings vary based on the dividend payout. Most companies pay at least a portion of their earnings to shareholders. In some cases, the company may even send 100% of its profits to shareholders. New companies usually spend less on dividends and put more towards retained earnings. This gives them extra money to expand the business or develop new products. Companies with low dividend payments may also have a plan for generating additional revenue in the future. Most companies take a more balanced approach by delegating a certain portion of funds to shareholders with some left over for retained earnings.
Retained earnings are often expressed as a percentage of a company’s total earnings. This is known as the retention ratio. It is equal to 1 minus the ratio of dividends payouts.
Companies will also release a retained-earnings statement to show how much they are spending on dividends and how much they are keeping in reserves. Knowing a company’s retained earnings can provide insight into the health of that company. How a company spends its retained earnings can tell you a lot about its priorities. A company with a lot of retained earnings may have a lot of debt, or it may be preparing to expand or merge with another company. A company with little retained earnings may be more focused on paying its shareholders.
You can also compare a company’s retained earnings to its historical records to see how it spends additional revenue over time.
Let’s use Apple as an example.
The company has seen a dramatic decline in retained earnings over the last several years.
In 2018, the company reported retained earnings of $70.4 billion. That dropped to $45.8 billion in 2019 and $14.9 billion in 2020 as the company paid more money to shareholders. In 2021, the company reported retained earnings of just $5.5 billion.
The company is one of the most profitable in the world, with well-known products that have dominated the market for years. More established companies tend to pay more to shareholders as they solidify their place in the market.
However, calculating a company’s retained earnings may not provide much insight into its overall performance. As an investor, it’s usually more helpful to know the returns these earnings generate over time, so you can find out if the company is putting its money to good use.
How Do Companies Spend Retained Earnings?
Companies can spend their retained earnings in a variety of ways, including:
Business Expansion or Development
Many companies use retained earnings to grow their operations by expanding to new locations, hiring more staff, or developing new products and services.
Companies can also use retained earnings to pay off existing debts and loans. Even though this money isn’t going directly to a company, it will still benefit its balance sheet and may help it save on interest.
Fund a Merger or Acquisition
A company can use the earnings to fund a merger or acquisition that ultimately benefits its business prospects. It may need to pay for lawyers and advisors during this time.
Buy Back Company Stocks
A company can use the extra profits to buy back some of its stocks. It may buy back stocks to consolidate the company or increase value equity. Buybacks only count as retained earnings if the company management uses the money to buy back stocks rather than paying the stocks to existing shareholders in lieu of dividends.
How to Calculate Retained Earnings
You can calculate a company’s retained earnings using the Retained Earnings Formula:
RE = Beginning Period (BP) RE + Net Income – Cash Dividends – Stock Dividends
Start by calculating how much a company already has in retained earnings. You can then add the net income from last month, quarter, or year. Now subtract the cash dividends and stock dividends to arrive at the total retained earnings.
Are Retained Earnings an Asset?
Are Retained Earnings a Liability?
Even though retained earnings mean money is coming through the door, they are considered a liability for the company. This money will need to be paid to shareholders in the event of a sale or buyout.
The Bottom Line
Retained earnings help investors learn about how companies spend their money. Management will have to decide how to use leftover money after the dividends have been paid. Keep this information in mind when assessing the financial health of a company.