Importance of Retained Earnings
Created on 01 Aug 2019
Wraps up in 7 Min
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Updated on 22 Oct 2020
When you start a business, you eventually start gaining the profits. So, is the entire profit given back to the owner? NO. It is because company would love to invest profit to the business again for future operations. Retained earnings are the part of net profit after tax that company has retained by not distributing to the shareholders to realize certain debts or used as an investment for future expansion plans.
It is an important source of internal or self-financing by a company. So, retained earnings are the cumulative amount of profit or loss left after paying all the expenses and dividend to the shareholders. The cumulative here means it is a continuing account year after year and doesn’t close at the end of the accounting year. The retained earnings are also known as earned surplus, retained capital, plowing back of profits or accumulated earnings.
In order for a company to grow, develop and expand it is ideal to use retained earnings for the accumulation of assets that generate income. The generation of income gives more cash flow to the company which gives means for expansion as well as increase its research and development programs. The increase in cash flow of the company helps to improve financial status and makes it favorable in eyes of investor. Retained earnings is favorable for the companies as issuing of new capital is a lengthy process as well as includes several costs, financial obligation and increased risk.
- Permanent Source: The moment company retains the money in business, nobody can take that from business which helps to keep the financial structure of company fully flexible and increase the creditworthiness of the company. So it is a permanent source of finance for the company.Due to the retention of earnings the growth and modernization plans of companies don't suffer due to lack of finance.
- No Explicit Cost: Compared to other sources of finance even equity shares or debt, company have to pay some cost as interest or dividend. There is a cost attached to it, company have to bear but in retained earnings we don’t have to pay anything to anybody because it is company’s own money.
- Great Degrees:The retained earnings do no not dilute the ownership of the company resulting in greater operational freedom and flexibility. Company can utilize in any way the business wants. No terms and conditions are applied for realizing the retained earnings.
- Absorb losses: The retained earnings help to incur the unexpected losses and company can continue with its business. The company with retained earnings can face unforeseen contingencies, capital market crisis and other downturns.
- Increase Market Price of Shares:When your retained earnings keep on increasing, company’s market price also increases. When investor invests in company he analyze the balance sheet and see the net worth of the company. Whenever company is dissolved the retained earnings are distributed amongst the shareholder and because of this scenario the market price increases.
- Dissatisfaction:There is dissatisfaction among shareholders. They don’t like retained earnings higher as it decreases their dividend.
- Uncertain:The profit earned by the company keeps on changing from year to year. So, the retained earnings is uncertain source of finance.
- Opportunity Cost:Everything has an opportunity cost associated with it.It is equal to the income that the shareholders could have otherwise earned by placing these funds in alternative investments.
- Over Capitalization: The excess of retained earnings will tempt management to issue bonus share which will lead to over capitalization in business.
Why retained earnings is not an asset?
Retained earnings are hold back after paying dividend, anything after the net profit is owner’s fund and owner’s fund is a part of liability.
Retained earnings are not considered as assets in itself but are used to buy future assets for the company or to realize the liabilities. Retained earnings may be regarded as extra profits but are not permanent to the company as they are kept aside to realize future loans or to invest again for the betterment and growth of the company. Retained earnings are always considered as credit transaction for the company until and unless these are retained losses.
How these retained earnings are reinvested?
Notably, retentions are a sacrifice made by equity shareholders for future investment. The company always looks for some who can invest in their company for growth, expansion and diversification. Therefore, it is ideal if company will retain its profit with itself so they can manage their task more efficiently as it will save their time to issue capital. The boards of directors decides how much amount of retained earnings they want by concluding between different factors i.e., tax to be paid, dividend to be paid, amount needed for reinvestment and expansion.
Retained earnings have the following four components:
- Last Year Reserves: as we know, retained earnings is a cumulative part of net profit means every year company makes profit and retains a portion of it rather than distributing. The continuously growing retained earnings show that company is making profit and building good fundamentals.
- PAT: profit after tax, we also call it net profit. Retained earnings will grow year – on - year basis only if the profit after tax is high.
- Dividend: anything after PAT is the right of shareholders but to maintain retained earnings the shareholder only gets portion of it as dividends on their invested amount.
- Depreciation: Depreciation is a non – cash expense for the company which Means that the company has not spent this money, it is just shown in the profit and loss account, as expense, as an accounting rule.
It is an obligation and duty of the top management to use retained earnings in an efficient way. Retained earnings are actually shareholders money. So, when a management decides to retain profits, they must ensure that the amount is invested properly.
We can see in the above flow chart that retained earning ultimately settles as “cash” in the company’s balance sheet.
There is no specific rule or guideline to use retained earnings by a company. But for sure no company will keep it idol as “cash or cash equivalent”. Company will invest it in better alternatives than cash
- Reduce Debt: Debt is the company’s liability. Liabilities of the company shrink its net worth and make it less attractive for the investors. The lower the amount of company’s liability, lower will be the expenses and risks associated with it.
- Buy Fixed Assets: The company use retained earnings to buy the asset to expand and grow the business which increase the profit of company. It is important to consider the opportunity cost closely to purchase one asset over another.
- Buy Investments: Company can buy different investment instruments like bonds, fixed deposits, mutual funds, stocks in secondary market, takeover of another company, real estate, funding start-ups etc. The company can invest in other avenues if the reinvesting back in own business is not that much profitable.
- Keep Liquid Cash: In our personal life also, we keep some cash with us to maintain balance, so, it is same with the corporates.The cash needs required depends on the consumption pattern of the company as well as the working capital cycle and collection of payment period. For ex: FMCG sector consumption is high but payment comes when the consumer buys the good, so they need to maintain high retained earnings for proper working.
After-effects of ‘good utilization’ of retained earnings-
- Income Increase: The company utilize the retained earnings to buy an asset or realize its debts which will increase the income potential of the company, if utilized proper manner.
- Net Profit Increase: With the buying of asset and other efficient utilization of retained earnings, it will make the company valuation more strong. It will earn more and spend less for the operations. Hence the company will make more profits.
- EPS Increase: When the net profit of a company increase it will eventually leads to higher EPS. A higher EPS indicates more worth because investors will willing to pay more for a company with higher profits.
- Market Price Increase: When EPS is increased, market price will also increase at a similar pace. Here, the shareholders actually benefit from retention of earnings over a period of time as they can sell their shares in open market.
- Retained earnings is an important source of capital gain for companies.
- Retained earnings are the funds which is available with companies over which management has complete control regarding their utilization.
- Retained earnings plays a crucial and important part in exerting influence and getting finances for investments when supply of funds is limited on account of poor profits.
- Profitable firms needs to borrow less because they have retained earnings which reduced their dependency on external sources of funds which involves heavy cost.
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