Retained Earnings Definition: Meaning, Formula, Examples, Advantages & Limitations

Every business is confronted with a fundamental question: Should it distribute profits to shareholders (in the form of dividends) or retain those profits to support growth? The answer is often found in retained earnings. Retained earnings are much more than a number appearing in the stockholder equity section of a balance sheet. In this guide, we will address the retained earnings definition, present practical examples of retained earnings calculations, outline the various features, benefits, drawbacks, and the role of retained earnings in financial ratios. By the end of this guide, you should understand why retained earnings are often referred to as “the backbone of sustainable business growth.”

What is Retained Earnings? (Definition & Meaning)

Retained Earnings are total earnings that a company retains for reinvestment purposes rather than distributing as dividends, which can be used to invest in the company or to pay down debts, which are shown under shareholders’ equity on the balance sheet. The amount of earnings a company decides to retain is based on the company’s dividend policy and management decisions to invest growth or risk.

Retained Earnings Formula with Examples

Retained earnings are calculated using the formula:

Ending Retained Earnings = Beginning Retained Earnings + Net Income (or Loss) − Dividends Paid

• Beginning Retained Earnings is the balance carried over from the previous accounting period.

• Net Income (or Loss) is the profit or loss the company earns in the current period.

• Dividends Paid are the profits distributed to shareholders as a return on investment.

Example 1: Positive Net Income 

Suppose Bright Ideas Co. starts a new period of financing with $200,000 in retained earnings. During that period, the company earns $50,000 in net income and pays $20,000 in dividends to its shareholders.

200,000+50,000−20,000=230,000

When they complete the period they will have $230,000 in retained earnings, which presumably will either be reinvested or used for any dividends in future periods..

Example 2: Net Loss with Dividends 

Bright Ideas Co. begins another period with $250,000 in retained earnings. They incur a net loss of $20,000 and pay dividends of $15,000.

250,000−20,000−15,000=215,000

Retained earnings begin at $250,000, but after the loss and dividends, it will go down to $215,000, even though the company paid dividends.

Example 3: Net Loss Without Dividends 

If the same company begins with $10,000 in retained earnings and incurs a loss of $25,000, without paying dividends:

10,000−25,000= −15,000

Your retained earnings are now in a negative position (accumulated deficit) that indicates the company is incurring losses, which can deteriorate your overall position.

Features of Retained Earnings 

1. Cushion of Security

Retained earnings provide the organization with a potential buffer to sustain itself during uncertain economic conditions, unforeseen market alterations, or surprising financial setbacks. These internal funds create a financial margin of safety and allow business continuity during difficult circumstances.

2. Funds for Innovation

Retained earnings are versatile as they can be a source of capital for it to deploy into innovation, research, and development. By leveraging retained earnings, the company can address new sources of technology, new markets, and an improved competitive position without waiting for an external source of funding.

3. Medium to Long-term Finance

Retained earnings are a source of internal equity capital, which are generally best used to support mid- to long-term corporate objectives like expansion, updating facility infrastructure, or diversification of business operations. And since these funds are internal, they provide long-term stability in thinking about future sustainability and financial planning.

4. No Cost of Financing

Unlike loans and other varying forms of external borrowing, retained earnings don’t come with interest payments, service charges, or repayment schedules. Thereby, retained earnings are a more economical form of financing that can help the organization grow and reinvest, without increasing the burden of capital obligations.

5. Control Retention

By relying on retained earnings instead of issuing new shares, the company protects the ownership structure and decision-making power of the existing shareholders over their business. This prevents the dilution of control on future decision-making and maintains an alignment with the original vision of the company.

6. No Legal or Flotation Costs

Accessing retained earnings (RE) is easy and cheap as it is only required to management’s formal resolution to utilize retained earnings. This avoids the legally burdensome processes and administrative steps required, or the costs involved with obtaining it through a public offering or thru borrowing from a third-party lender.

Advantages of Retained Earnings for Companies

1. Cost-Effective Financing: One big plus of keeping earnings is there’s no need to pay them back or worry about interest. Companies can put the money back into the business and keep their cash flow steady. This is key for running things daily and planning for the future.
2. Flexibility: Unlike getting money from outside, kept earnings let you be in control. The company leaders decide how and when to use the money based on what’s important, the plans, or new chances, without owing anything to lenders or investors.
3. Financial Stability: When profits pile up, the company’s financial standing looks better, with strong equity and reserves. People will trust the company more. It gets simpler to get good loan terms if you need money.
4. Easy Source of Financing: Kept earnings are like a stash of cash the company can use when sales are down or money gets tight. Using this fund means less need to borrow, which protects against debt problems and keeps the business running.
5. Supports Growth: Companies can use their profits to fund growth by putting money back into fresh projects, growing into new markets, or updating how they work. This way of funding lets them grow without needing outside money, which helps them stay competitive over time.
6. Ownership Retention: Since using profits doesn’t mean creating new shares, current owners keep their say in how things are run. This keeps their voting power strong and helps the company keep a steady course.
7. Improved Company Image: Having a good amount of kept profits shows a company is careful with money, makes money well, and can bounce back from tough times. People watching the company, like investors, see this as a sign the company is steady and growing, which can make the stock price go up and pull in investors who want to stick around.

Limitations of Retained Earnings 

1. Potential Shareholder Discontent: Keeping profits helps a company’s finances, but it can upset shareholders. Many investors want regular income and like dividends more than seeing profits always reinvested. This can cause problems since shareholders might think their returns are being held back for the company’s future goals.
2. Risk of Inefficient Use: Keeping earnings doesn’t always mean good results. If leaders don’t put the money into good investments, the reinvested money might not make much profit. In these cases, not paying dividends can hurt the company by lowering shareholder trust and company value.
3. Opportunity Cost: Using retained earnings for funding ties up company resources, so the company might miss other ways to get money. External funding, like low-interest debt or equity from the market, could give better returns. If a company only uses retained profits, it might miss chances to grow faster.
4. Not a Source for Immediate Cash Needs: Retained earnings aren’t usually held as cash. Instead, they’re put back into the business through things like assets or projects. This means the money isn’t readily available to give out to shareholders. This can make it difficult for a business to handle immediate money needs or sudden financial issues..

Impact of Retained Earnings on Financial Ratios 

Return on Equity (ROE)

Retained earnings increase the owner’s equity on a company’s financial report. Return on equity (ROE) measures how well a business makes money from its owner’s equity, so putting retained earnings back into the business can really change this number. If the money is put into projects that make a good profit, ROE will go up. But if the returns are so-so, it could lower overall profitability.

For example, Apple puts some of its earnings back into creating new things, like iPhones and Apple Silicon chips. Because they’ve made smart reinvestment choices, Apple has kept a good ROE, which shows they can make a lot of money from owner’s equity. On the flip side, some older car companies in the 2000s kept too much money but didn’t reinvest it well. This led to weaker ROEs because their growth was slow.

Debt-to-Equity Ratio

Retained earnings make a company’s equity stronger, so it doesn’t need to borrow as much money. If a company doesn’t owe much compared to its equity, it’s more financially stable. This makes it easier for the company to borrow money when it needs to. Basically, retained earnings give a company a way to fund itself, which lowers the risk of not being able to pay its debts in the future.

For example, Infosys in India has always had a strong equity base and hasn’t owed much money. It has mostly used retained earnings to fund its activities. This good money management is shown in its healthy debt-to-equity ratio. Because of this, the company doesn’t have to worry about high interest payments and can keep money available for growth. On the other hand, companies that borrow too much money, like Evergrande in China, show the problems that can happen when companies don’t rely enough on retained earnings and borrow too much. This can lead to financial problems.

Dividend Payout Ratio

This ratio shows how much of a company’s profit is paid out as dividends versus how much is kept for reinvestment. Companies that want to grow fast usually have lower payout ratios since they keep more earnings to pay for expansion. But mature companies in stable industries might pay out a larger part of their profits to keep investors happy.

For example, Amazon is known for never paying dividends. Instead, it puts its retained earnings into business expansion, cloud infrastructure (AWS), and worldwide logistics. This reinvestment plan has led to huge long-term growth and increased owner wealth, even though the payout ratio is low. Coca-Cola, in contrast, pays a high percentage of its earnings as dividends. This shows that it’s a mature company in a stable market and is dedicated to regularly rewarding its owners.

Retained Earnings vs. Dividends: Which is Better?