What are Retained Earnings?
Retained earnings may be familiar to those who invest in companies as shareholders, and they are certainly familiar territory for any company that has shareholders. In this definition, the word earnings does not mean employee earnings but it is used to discuss company profits. These might normally be paid out as dividends to investors but it is not unusual for the company to keep some profits held back or to retain them.
There are several reasons why companies keep back these payouts. Theoretically, companies mostly use retained earnings to reinvest in the business. This reinvestment holds with it the promise that companies will grow and make yet more money in the future. Some of this will be disbursed as dividends and some of it will still be retained for greater investment. A healthy company is typically one that is growing, that is increasing its yearly earnings and not falling behind, or simply trying to keep up with expenses. In this ideal scenario, the company keeps back money as a means of making the itself more profitable and successful, and it might spend some of the retained earnings in things like acquisition, research, new facilities, or marketing.
In some examples of retained earnings, companies are trying to keep their heads above water. They have to reinvest in equipment that breaks to keep earning a steady amount, or they continue to be in debt and have to reinvest money retained into repayment of debts. In these cases, company action is important but it doesn’t say much about the company’s ability to grow in the future. When companies continually retain earnings just to maintain the same status or to keep from losing more money, they may not be the soundest investments. Those skilled in advising investors often suggest looking for those companies that use retained earnings wisely and well for growth.
Retained earnings are also defined in a simple formula. This is the total of all retained earnings at present added to the net income made by the company. Total amount of dividends paid is subtracted from this account to get year-end or quarter end retained earning statements. The amount of money that is actually available after it has been retained isn’t always the same as the total earnings stated. Typically the money has been invested, so it is not necessarily available to the company or to shareholders. Rather, many see any total figures here as money that has been invested to grow the company.
In my experience, some of the older, stable companies that are doing well, but aren't growing rapidly, are often good stocks to invest in. These companies use their retained earnings to pay pretty good stock dividends to their stockholders.
They put some of their earnings into upgrading their company and into investments, but they have enough left to reward their stockholders with generous and consistent dividends.
Companies that are growing fast have to put a lot of their earnings back into the company, and can only give small dividends or none at all.
Anyone who wants to have a reasonable chance of making money in the stock market needs to know something about retained earnings. It's also a good idea before investing in a company to look closely at their retained earnings and the history of the dividends that they give to shareholders.
It takes a lot of homework to keep tabs on how companies use their retained earnings. Some spend a lot on research and development. But others need to use it bring their company up to par. And others are trying to catch up for mistakes in marketing or production or negative public relations.
So when choosing companies to invest in, find out as much as you can about the way they use their retained earnings.
@speechie - I have heard that about small businesses, that you really have to love what you do and you have to stick it out through those tough first years when you are putting in a ton of hours and obviously not able to "pay yourself" much.
I think you would calculate retained earnings based on how much you wanted to reinvest into the company, based on what the article discussed. So maybe you might decide what upgrades your company needed, and then figure out how much these upgrades might cost and then retain the money.
But I think the importance about retained earnings is that the article talked about it being money that would normally go to investors.
This makes me think it is term for companies that have investors, so maybe this term only relates to publicly traded companies or maybe it can describe any company who has investors and retained profits instead of putting the money towards the investors.
I am glad I looked this term up! I was guessing and thought that a retained earnings example was something along the lines of when part of person's paycheck is retained to pay back a debt involved in a legal matter such as child support payments.
I was quite off. I am also sad that I did not know what this is because my husband built a small business, so I feel I should have known what it was.
But now that I know what it is I realize - no wonder I did not know it - when you are just beginning to build a small business you are excited about any profit and therefore you are not so profitable yet that you can start discussing retained earnings.
How does a company calculate retained earnings, as in how much profit they are going to retain?
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