Retained Earnings

What are Retained Earnings?

When a company turns a net profit, they can elect to either pay it out as a dividend or take these earnings and reinvest them back into the company.  In the case of the latter, the company will record these earnings as retained earnings which will be recorded on the balance sheet under shareholders equity.  If the company turns a net loss for the reporting period, the loss decreases the retained earnings balance.

Investors will closely monitor the usage of retained earnings by management to determine if the funds are being used appropriately.  If they do not see a significant return on investment, investors will demand that they be paid a dividend instead of reinvesting the earnings.

Uses of Retained Earnings

For many companies, retained earnings will be used to expand their business model; while for others, it is used as a means for acquiring new equipment or servicing existing equipment.  For this reason, investors would rather be paid out in dividends; it typically takes the company a very long time to recover a decent return on invested funds when they are used for such expenses. 

Smaller, high growth companies are prime candidates for putting retained earnings to good use.  Typically, investors will encourage these companies to reinvest into high growth, high yielding investments.

Generally speaking, the easiest way to measure the return on the use of retained earnings to measure the change in the price of the common stock against the amount of retained earnings per share utilized to achieve this gain.  Obviously, this return is questionable as stocks can be trading at levels which are at a large premium or discount to the book value of a company. 

Calculating Retained Earnings

Retained earnings can be calculated by using the following formula:

RE = Retained Earnings from Prior Period + Net Income - Dividends Paid