What Are Retained Earnings?
Written by Eddy Hood
This accounting term relates to the financial value that a business has built up over time.
By definition, a corporation has shareholders who have partial ownership of a company but are not financially liable for its actions. Those shareholders earn a portion of a company’s net earnings, which are paid out as dividends. These dividends, often paid out quarterly either as cash or stock in the company, are like a reward for a shareholder’s investment.
What Are Retained Earnings?
So what are retained earnings? This term refers to the profits retained, or held back, from the shareholders and not paid out as dividends. Corporations and S corporations need to take back a bit of their net income in order to continue to function and grow. This percentage of net earnings is held back and redistributed into the business, either to invest or pay debts.
What They Aren’t
Many people in the public are often confused about what is not considered to be a retained earning and what is. Retained earnings, first of all, must be reported in the balance sheet given to shareholders. It’s not a hidden or mysterious amount that isn’t revealed when one invests in stock. It can be found easily under the shareholders’ equity section of the balance sheet or sometimes even in a separate report. This amount is also not static but frequently adjusted and evolved to react to company changes and needs. If the company is less profitable or has a net loss, that affects what is retained. Earnings retained by the corporation may turn into retained losses or accumulated losses in that case.
How Earnings Are Reinvested
While operating a public business, a board of directors will need to decide how to wisely invest their retained earnings. Every investment needs to result in a return on that investment (or ROI). For corporations and S corporations, the goal is almost always growth. That means that companies will often invest in research and development of new products with their retained earnings. A board of directors makes the decisions on what to retain based on several key factors, such as the dividend policy, the tax treatments, the amount of profit, the amount of expansion desired, and the amounts required to reinvest.
Why Retained Earnings Are Important
In order to grow, a business needs to constantly invest in itself and in new products. If you are a shareholder, you should expect to see some retained earnings on the balance sheet. This is normal and needed if a business wants to maintain operations, increase sales, grow as an enterprise, or expand services. If a company wisely spends its retained earnings, the stock will slowly increase. If the stock value decreases or remains stagnant, it’s often a sign of a poor investment.
If you’re the owner of a small business that’s looking to become a corporation, or if you’re looking to become a shareholder, you’ll want to learn more about these accounting terms from the experts at Ignite Spot. We’re an online, outsourced bookkeeping firm that offers valuable accounting services and can serve as a CFO for your company. Contact us today or feel free to download our free online tools.