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Looking at your company’s balance sheet, there are all sorts of numbers and values, but one that you don’t want to overlook or misunderstand is retained earnings, which are sometimes called accumulated earnings.
Retained earnings represent a part of the net profit (income) that a company makes. These earnings aren’t paid out as dividends. Instead, as the name implies, this money is retained in the company.
How Are Retained Earnings Calculated?
Retained earnings are calculated by adding net income to previously retained earnings. Any net dividends that have been paid to shareholders are then subtracted. The final number is the amount of retained funds for your business.
Retained earnings are calculated quarterly and annually. Depending on your business’ net income, paid dividends, and losses, retained earnings can either be positive or negative. For example, if your company pays a large number of dividends that surpass other figures, you may have negative retained funds. Other factors that impact retained earnings include:
- Depreciation
- Operating expenses
- Sales revenue
- Cost of goods sold
Understanding how retained earnings are calculated can help shape business decisions, such as paying out dividends or using these earnings within the company.
How Can Retained Earnings Be Used?
So what can you do with retained earnings? Most business owners use them by reinvesting them into the company. You can use these funds to buy more office space, pay off debt, or to purchase much needed IT equipment such as laptops, tablets, and work phones for employees.
Retained earnings can also be used to:
- Launch a new product
- Fund a company merger, partnership, or acquisition
- Share buybacks
Some companies choose to distribute some or all retained earnings, in dividends, to business owners. If you choose to pay out earnings as dividends, make note that the money is moving out of your business completely as dividend payments cannot be reversed.
To get the most use from retained funds, it’s generally best to use the money to improve your business. This way there’s a measurable benefit by using the money your business has retained throughout the year.
Determining Whether to Pay Out or Retain
When your company has surplus income, long-term shareholders are likely to expect regular dividends to be paid out to them. It only makes sense to give back to those who have been putting their own money into the company. Shareholders typically prefer dividend payments as they’re typically seen as tax-free income, unlike stock options which are subject to taxes and other fees.
However, as the company owner, you may find that retained earnings can be better utilized if they’re kept within the company. Shareholders may trust the direction of your business and allow you to retain their earnings in hopes of higher returns in the future.
Generally, the decision to distribute or retain these funds depends on company managers, but, the decision can be challenged by shareholders as they are the true owners of the business.
So how do you decide which option is best for your company? There are all sorts of factors to consider. First, take an in-depth look at the current market and market predictions. If there’s high growth in sight, it makes sense to retain the funds in hopes of generating even more substantial returns in the future.
Another situation that makes the most sense for retaining the earnings is if you have a high-interest business loan to pay off. By paying a large amount of money towards the loan, you’re able to save hundreds, possibly thousands of dollars towards interest.
As a business owner, be aware that retained earnings don’t have to be retained or dispersed. If you find that a happy medium between the two is the best option for your company at the time, then take that approach. Figure out which scenario provides the best outcome for ensuring satisfied shareholders while also having money for internal use.
How Dividends Impact Retained Earnings
When paying dividends from retained earnings, they can be paid in cash or stock options. No matter how you pay the dividends, the result is a reduced number of retained earnings. If you decide on cash payments, this is considered cash outflow and should be recorded as a net reduction.
If dividends are paid out in stock, there is no cash outflow. An increase in shares doesn’t impact the balance sheet but it does decrease per-share valuation. This data is tracked in capital accounts.
Conclusion
Even if you’re not an accountant or a number cruncher, it’s important to know the ins and outs of your company’s financial statements, including retained earnings and how they can be used. Be sure to keep this information in mind to make the most beneficial decision when deciding what to do with retained funds.