Retained earnings

Retained earnings - it can be a synonym of a profit, which stays in the company. Usually, when the company is earning profit, part of it is used to finance important concerns of the company and the other part, stays in the company for further growth and investments. That part of a profit, which is carried forward to the next year and used for improving company’s competitiveness, is called retained earnings.

To understand it clearly, let’s say, that the company earned some of Net Income. It is the same income, taken from the company’s profit/loss statement, which is calculated when deducting cost of sales, operating and financial expenses from the received sales. That profit can be used in many different ways - it can be committed to the reserves for buying own shares, committed to the reserves, which is used to compensate the losses of the company. It can also be paid as dividends for shareholders and for yearly bonuses for the board of directors and company employees and other purposes. Everything what left from these expenses is retained earnings. It is under shareholders’ equity in the balance sheet. Usually it is used for investments or for paying the debt of the company.

The formula to calculate the retained earnings is to add net income and deduct dividends and other bonuses from the retained earnings at the beginning of the period. In numbers it would look like this - the company had 10000 Euros of retained earnings last year, and earned 50000 Euros of net income this year. Annual meeting of the company decided to put 10 percent of the net income to the reserves and to pay out another 10 percent as bonuses for the best employees and board of directors. Other 20000 Euros was committed for paying dividends for the shareholders of the company. Because the company is planning to expand in the near future, it is accumulating resource for it, so the rest of the net income, which is 20000 Euros, was committed to the retained earnings. So the retained earnings for this year will be 30000 Euros (including retained earnings from previous year).

If a company incurs losses, it’s needed to deduct retained earnings from the previous years. It means, if a company had 10000 Euros of retained earnings from the previous year, and it incurred 3000 Euros of loss this year, then no dividends will be paid and nothing will be committed for reserves or bonuses, but this amount will be deducted from those 10000 Euros, so the retained earnings for this year will be 7000 Euros. As you can understand, retained earnings can be carried forward - it can be negative as well, if a company incurs losses several years in a row or the losses are bigger than the sum of retained earnings.

For the investor it is useful to check whether the retained earnings of the company is positive or negative and if the company’s retained earnings are increasing or not. If the investor is expecting the growth in the company’s value, the retained earnings should be growing in the company, and even if the company decides not to pay dividends few years, it is useful to think that the company is accumulating retained earnings for expanding its business area or it is planning to invest in better technology, which will create higher value of the hole company, the greater price of the shares and greater dividend payouts in the future.

Other ratio groups:
EBITDA
Value ratios
Efficiency ratios
Profitability ratios
Liquidity ratios
Leverage ratios
Other financial ratios
EBITDA
Efficiency ratios