What Are Retained Earnings? Importance, Calculation, and Factors That Affect Them

Investors should pay close attention to a company’s retained earnings, as they provide insights into the company’s financial health and growth prospects. By analyzing a company’s retained earnings, investors can gain a better understanding of its profitability, cash flow, and future investment potential.

Retained earnings refer to the portion of a company’s profits that are not distributed as dividends to shareholders. Instead, they are kept within the company to fund various business-related activities. These activities can be operations, repaying debt, or investment in growth opportunities.

Retained earnings are an essential component of financial accounting, as they represent the accumulated profits of a company over time.

According to R. Narayanaswamy in his book “Financial Accounting: A Managerial Perspective,” retained earnings play a crucial role in a company’s financial stability and growth prospects.

• Future Growth: They provide a source of funding for future investments, such as research and development, new product lines, or expansion into new markets.
• Debt Management: Retained earnings can also be used to pay off debt, which can reduce interest expenses and improve a company’s credit rating.
• Emergency Fund: In addition, retaining earnings can help companies weather economic downturns, as they provide a cushion of funds to sustain operations during difficult times.

Retained earnings are an important metric for investors, creditors, and other stakeholders. It is an indicator of a company’s profitability and long-term financial health. By retaining earnings, a company can demonstrate its commitment to growth and financial stability. The retained earning can also provide value to shareholders through potential future dividends or share price appreciation.

Let’s dig more into the concept of retained earnings.

Investors Must Know About Retained Earnings

Why investors must have detailed knowledge about retained earnings? Because it is the money of the shareholders.

When we buy stocks of a company, we are actually buying a share in the company’s net profit (PAT). Technically speaking, the net profit is the owners’ money. Who are the owners of a publicly traded company? It’s the shareholders. How shareholder can get hold of the net profit? In form of dividends.

Retained earnings are that portion of a company’s profits that are not distributed as dividends. Most companies, often retain a chunk of their net profit and this retained profit is visible as “Reserves & Surplus” in their balance sheet.

Calculation of Retained Earnings

Retained earnings can be calculated by subtracting the total dividends paid to shareholders from the company’s net profits (PAT) over a specified period. The formula for calculating retained earnings is as follows:

• Beginning retained earnings refer to the balance of retained earnings from the previous period (say FY 2020-21). It serves as the starting point for calculating the current period’s retained earnings.
• Net Profit (PAT) refers to the total profits earned by the company during the current period (say in FY 2021-22).
• Dividends refer to the portion of profits that are distributed to shareholders as cash in the current period (FY 2021-22).

The calculation of retained earnings is a critical aspect of financial accounting, as it provides valuable information on a company’s ability to generate profits and retain earnings for future growth.

Retained Earnings Calculation Example

Let’s see an example of how companies prepare their retained earnings statement for each financial year:

• Step #1: Note the retained earnings balance of the previous year. In our example, this number shall be taken from the balance sheet of FY ending Mar’21 (72,262).
• Step #2: Note the net profit reported for the current year. In our example, the net profit reported for Mar’22 is 43,963.
• Step #3: Note the total cash dividend paid (as reported by the company in the current financial year. In our example, the total dividend paid is Rs.3,004.
• Step #5: Calculate the current year’s retained earnings by adding the values of steps #1, and #2, and then subtracting #3 from it. In our example, current year retained earnings will be 1,13,221 = 72,262+43,963-3004.

Importance of Retained Earnings

Retained earnings are a critical component of a company’s financial health. They represent the portion of profits that are kept within the company for future use. Retained earnings play a vital role in financing a company’s operations, funding growth initiatives, paying dividends to shareholders, and clearing loan outstandings.

• It Finances Operating Activities: One of the primary uses of retained earnings is to finance a company’s ongoing operations. By retaining earnings, a company can ensure that it has sufficient funds to cover day-to-day expenses, such as salaries, rent, and other operating costs. This can help improve a company’s financial stability and reduce its reliance on external financing sources, such as loans or equity financing.
• It Finances Future Growth Plans: Retained earnings also provide a source of funding for future growth initiatives. These initiatives can be R&D, new product lines (CAPEX), or expanding into new markets. A company can invest in these growth opportunities without having to rely on external financing, which can be more expensive or difficult to obtain.
• Ensure Shareholder’s Value: It can also be used to pay dividends to shareholders or buy back shares from the secondary market. While not all companies pay dividends, those that do can use their retained earnings to finance these payouts. This can be an attractive feature for investors, as dividends provide a steady stream of income and can increase a company’s share price.
• Paying off Debt: Retained earnings are also used for repayment of the already incurred loans (the principal component).

The Use of Retained Earnings (Schematic Representation)

This schematic representation of the application of retained earnings explains how a company accumulates and uses this fund.

• Stage #1: The company generates income from its business. Net of all expenses is the company’s net profit. After the dividend payment to the shareholders, what remains is the retained profit of the company. It is reported in the company’s P&L account.
• Stage #2: The reported retained profits of all previous years are shown as accumulated retained earnings in the company’s balance sheet. As the company converts its non-cash current assets into cash (like receiving customer payments), the portion of cash in the current assets begins to grow.
• Stage #3: In this stage, the cash with the company is ready for onward usage. the first priority of any company is to manage its working capital. Then they can this cash to manage other priorities like future growth plans, dividend payments, loan repayment, shares buyback, etc.

How To Know, if the Retained Earnings Are Being Used Properly or Not?

The company has retained the profits to improve the returns for its shareholders. How? By assuring faster market price appreciation of its shares and periodic dividend payments.

• #A. Income Increase: A company that is utilizing its retained earnings properly, by expanding and modernizing its facility, will eventually increase its income (revenue).
• #B. Net Profit Increase: Efficient utilization of retained earnings will make the company more efficient. It will spend less and earn more. Hence the company will make more profits.
• #C. EPS Increase: An increase in net profits eventually leads to higher EPS (Earnings Per Share). This should be the ultimate objective of a company. A continuously growing EPS is a good indicator of the effective utilization of retained earnings.
• #D. Market Price Increase: When EPS grows, the market price will also grow at a similar pace. The shareholders actually benefit from the retention of earnings over a period of time.

A company that displays a high or improving ROE, ROCE, or ROIC is a strong indicator of fair utilization of the company’s retained earnings.

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Example #1 – VIP Industries

In the last 5 years, the company has retained 48% of its profits and paid the balance as dividends. Let’s check how well the company has used the retained.

In the last 5 years, the company reported a price growth rate (12.57%) higher than the rate of growth of its reserves (2.89%). This is a positive sign. But the price is not a great indicator of the underlying fundamentals of the company.

The main task of retained earnings is to improve the company’s fundamentals in the long term (like 5 years). But the ROCE and EPS have shown negative growth rates in the same period. So, as an investor, I will look at a better investment alternative.

The above number of VIP Industries can also be a rough indicator that, currently, the company’s price levels may be at overvalued levels.

Example #2 – Integra Engineering

In the last 5 years, the company has retained 100% of its profits and paid no dividends. Let’s check how well the company has used the retained profits.

In the last 5 years, the company reported a price growth rate (12.03%) slower than the rate of growth of its reserves (36%). This is not what the shareholders of the company would like to see.

But the ROCE (12.89%) and EPS (21.61%) have shown positive growth rates in the same period. ROCE growth at this rate is not common. A company, that is able to grow its ROCE and EPS at these rates demands more attention in terms of market price appreciation of its stocks.

Hence, I will assume that at Rs.90 per share level, the company’s share price may be at undervalued levels.

The Affecting Factors

There are many factors that can impact retained earnings, the most significant ones are a company’s net profit and dividend payouts. By understanding these factors and analyzing a company’s retained earnings, investors and other stakeholders can gain valuable insights into its financial health and long-term prospects. Let’s see how:

The Factors

1. Net Profit: The most significant factor that affects retained earnings is the company’s net profit (PAT). Higher net profit means more retained earnings, that can be used to finance future growth initiatives or pay dividends.
2. Dividends: The amount of dividends paid to shareholders is another key factor that affects retained earnings. If a company pays out a larger portion of its net profits (PAT) as dividends, it will have less retained money for other important uses.
3. Shares Buyback: If a company decides to buy back its own stock, it can also impact its retained earnings. By buying back shares, the company reduces the number of shares outstanding, which can increase earnings per share. This process, in turn, boosts the share price. However, buying back also reduces the amount of retained earnings that could have been used for other purposes.
4. Asset Write-Downs: Suppose a company needs to write down its asset worth Rs.1 crore. The company must recognize Rs.1 crore expense in its P&L accounts. This will reduce its net profit for the period. If the net profit, before writing down, is Rs.5 crores. Then after writing down, the net profit will be only Rs. 4 crores.
5. Changes in Accounting Rules: For example, companies are allowed to spread their depreciation and amortization (D&A) expenses over a longer period. But if this rule changes and the company account for this expense upfront, it will reduce its PAT. In turn, it will reduce the company’s potential retained earnings due to this changed accounting rule. Read more about it here.
6. Foreign Currency Transactions: If a company records its balance sheet accounts in multiple currencies, fluctuations in exchange rates can change it. Changes in exchange rates can affect the value of a company’s assets, liabilities, and revenues, which can impact net income and, in turn, retained earnings.

How Does Depreciation Affect Retained Earnings?

I’ll share with you my personal confusion related to “depreciation expense” and its effect on retained earnings. As depreciation is a non-cash expense, I thought, why it is not carried over to the balance sheet (along with retained net profit) and added to the accumulated retained earnings?

[My confusion: The depreciation reported in the P&L account should increase the reserves. But in actual practice, due to depreciation, retained earnings are reduced (as net profit is reduced)]

To clear this confusion, we will have to understand what is depreciation expense and how is the cash flow happening related to depreciation. Allow me to explain it with an example. Suppose there is a company that purchased equipment in Mar’19 worth Rs.500 Crore. The life of this equipment is say 4 years.

Cash Flow: On the date of purchase of the equipment (Mar’19) the company paid the full Rs.500 crore to its supplier. How this cash out will be reported in the company’s financial statement?

The actual cash-out due to the purchase of equipment happened on Mar’19 itself. But the same need not be reported immediately as an expense in the P&L account. The cost of equipment purchase can be spread over the life of the equipment as depreciation (see the above infographics).

In this case, the life of the equipment was 4 years. Hence Rs.500 crore was evenly distributed as Rs.125 crore for the next 4 years (125×4 = 500).

Inference: Though depreciation is a non-cash expense for the current year, but the cash-out has already happened in the past. The present depreciation reported is an adjustment of the already-paid expense. But as we have not adjusted it then, the same is being reported now. Due to non-cash depreciation expense,there is no extra cash lying idle with the company. Hence, we cannot add depreciation to company’s retained earnings.

Conclusion

Retained earnings are an essential aspect of a company’s financial statements. Understanding them is crucial for business owners, investors, and other stakeholders.

Retained earnings indicate a company’s profitability and its capacity to fund growth initiatives or pay dividends.

By analyzing a company’s retained earnings, stakeholders can gain valuable insights into its financial health and long-term prospects.

It is important for investors to be aware of the factors that can impact retained earnings. By keeping these factors in mind, investors can make informed decisions about investing in a particular company.

Have a happy investing.

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