What is Retained Earnings?
The retained earnings are part of the net income or net earnings retained by the company after paying dividends to shareholders. In other words, retained earnings are a part of the net profit earned by the company in a financial year, and it is calculated to act as a fund for future projects, invest in other businesses, paying off debts, etc.
A company can have negative retained earnings. It is caused when a broad dividend distribution occurs that exceeds the balance of the outstanding earnings account or by the occurrence of a significant loss, which will create an offset in the retained earnings account.
Formula to calculate retained earnings:
Ending Retained earning = Beginning Retained earning + Net income (profit or loss)- Dividend
Let’s discuss the components of the formula:
Beginning Retained Earnings:
The Beginning RE is the accumulated surplus amount present in the account at the beginning of the financial year. This amount depends upon the profit or loss that occurred in the previous fiscal year. This value may be negative or positive.
Net income is the total amount earned by the company in a financial year, which can be calculated by deducting the expenses such as material cost, general and administrative expenses, salaries of employees, interest to be paid on debt and taxes from the revenue earned by the company.
If the revenue is more than the expenses of the company, then the company is said to be in profit; if not, it is in the loss.
The dividend is the portion of net income given to the shareholders as a reward to investment in the company. This dividend amount affects retained earnings. So, the more the dividend amount is given to the shareholders, the less the retained earnings.
Which is better, Dividend or RE?
As we learned, the dividend and Retained earnings are part of the net income of the company if one goes up, and the other goes down. So, which is better for investors or shareholders?
In general, investors may think that a company that does not pay dividends or increases its dividend value over the next few years does not work very well.
But this may not be the case, and the company may be retaining the amount to invest in other projects so that the company will grow at a higher rate and earn more income than the amount to be paid to the dividend. They are thus resulting in increased share prince of the company benefitting the shareholders.
And this may not be the case all the time, the management may not be able to generate good returns. The company may have a loss and lost a considerable amount. The company uses fraud accounting so that they can show a lower income to reduce taxes or pay loss divided amount.
Example of Retaining Earnings:
Let us assume that the Beginning RE of the company is $100,000, had a profit of $15,000, and the company decides to pay $3000 as a dividend to the shareholders.
The end retaining earning can be calculated by using the formula,
Beginning RE =$100,000
Net profit =$15,000
Ending Retained Earnings = 100,000 + 15,000 – 3,000 = $112,000
Now we have a fair idea of what the revenue is retained, and we have also seen the RE calculation. The company’s management can do it in order to maintain an excellent profit to meet the company’s capital needs to reward investors for their investment.