A company’s shareholders are the owners who can get hold of the profits but in the form of dividends. The company can even distribute 100% of the net profits to its shareholders as dividends. It is dependent on what the board of directors decide in the board meeting. However, companies can also retain a chunk of the net profit and carry it forward to next year. This amount is referred to as retained earnings.
What is retained earnings?
The company’s net profit is also referred to as profit after tax (PAT). If anything is retained by the company after paying out a dividend at the end of a financial year, it is known as retained earnings.
The new profits generated give room to the company’s management or the business owners to utilise the money for business. It can be reinvested into the company’s operations to grow the revenue and profits or be paid out to the shareholders as dividends.
Generally, the cumulative retained earnings in a company’s balance sheet are referred to as ‘reserves and surplus’.
Calculating retained earnings before you decide on stocks to buy today
The formula for calculating retained earnings is:
Retained Earnings = Current Retained Earnings + Net Profit/Loss − Dividends
While there are software available that check a company’s retained earnings, you can also calculate it manually by considering these three variables –
- Current/Opening retained earnings
- Net profit or net loss for the period under consideration
- Dividends (distributed in that specific period)
Retained earnings statement
Let’s take an example of company ABC established onJanuary 1, 2021. The retained earnings on the said date will generally be zero as the company has just started its operations.
Now let’s assume that the profit after tax for the quarter (January 2021 to March 2021) is Rs. 10,000, and no dividends are announced.
It means that the retained earnings as of March 31, 2021are Rs. 10,000.
Retained Earnings = Current Retained Earnings + Net Profit/Loss − Dividends
According to the above formula,
Retained Earnings = 0 + 10,000 − 0
= Rs. 10,000
Therefore, it can be said that the company earned profits of Rs. 10,000 and retained all of it.
Why do companies retain their profits?
These retained earningsare recorded in the company’s balance sheet under the term ‘Shareholders Equity’. These earnings are shareholders’ money, and therefore, it’s the responsibility of the company’s management to utiliseit as deemed fit, i.e. either retained into the business for future growth or paid as dividends to the shareholders or even for any other reasons like –
- funding workingcapital
- funding fixed asset purchase
- funding research and development, sales, shares-buyback or loan repayment
- retaining the earnings to pay dividends in the future
Looking to gauge a company’s performance before you invest in the stock market?
A look at a company’s retained earnings on its balance sheet can give you as an investor a fair idea of the company’s overall financial health. This is one of the key parameters before you decide on which stocks to invest in the stock market today.
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