The retained earnings account on the balance sheet represents the amount of money a company keeps for itself instead of paying it out to shareholders as dividends. Net income and dividends are the items that make retained earnings go up or down. Losses and dividend payments reduce retained earnings, while profits increase retained earnings.
The formula for retained earnings is net income in the period plus existing retained earnings less dividend payments. For example, if a company made a profit of $587,100 and its prior period retained earnings balance was $1,456,789, its new retained earnings balance is $2,043,889. If the company paid dividends of $145,679, the retained earnings account would show a balance of $1,898,210, or $2,043,889 minus $145,679.
Why It's Important
A company's balance sheet shows the company's net worth, which is a measure of its assets less its liabilities. This figure is accounted for in the "Shareholder's Equity" section of the balance sheet, which is where you'll find retained earnings. If a company chooses to grow its retained earnings rather than issue dividends, it's a sign that management would rather invest money back into the business. This is usually the case with fast growing companies that need the money to grow. A high retained earnings figure gives the company a cushion in case business turns sour. It also gives the company flexibility to do other things like pay off debt. Stable and mature companies, which have less financial volatility, usually favor issuing dividends to shareholders.
Retained Earnings and Dividends
The ratio of how much money a company pays in dividend vs. how much it decides to keep in retained earnings is of importance to investors. For example, investors who value dividends would obviously like to see a high dividend payout ratio. To calculate the ratio, divide the dividend payment by earnings. For example, if a company pays an annual dividend of $1.50 per share and its earnings per share is $3, this is 50 percent dividend payout. In other words, the company pays half of what it earns to its shareholders and keeps the other half in retained earnings. The portion the company keeps for itself is the retention ratio, which in this case is 50 percent.
Investors focus not only the balance sheet, but also a company's income statement and cash flow statement when deciding whether a company is worthy of investment. Taken together, the financial statements provide a comprehensive overview of the financial health of the company. It doesn't matter whether a company has high or low retained earnings -- what matters to investors is how the company uses the money. For example, a company might be building its retained earnings to make an acquisition or invest in a new project. On the other hand, a company might decide to keep retained earnings low because it is constantly putting money into projects or initiatives. What matters most is whether the strategy brings a decent return on investment.