What are retained earnings? Advantages and disadvantages

Creating and selling products and services is just the start of running a successful business. When revenue flows in, you need to decide how to allocate it strategically. For many companies, the decision lies between distributing dividends and retaining earnings to fund other business goals. This decision not only affects immediate financial stability but also long-term growth.

First, let’s understand what retained earnings are and how they can support various business goals. We’ll then weigh the advantages and disadvantages of retaining earnings, and discuss how much earnings businesses should retain.

What are retained earnings?

Retained earnings refer to the amount of profit that a business has left after paying dividends to shareholders. It's also known as “retained profits”, “trading profits”, and “earning surplus”. Retained earnings measure how well a company is doing financially. They show the amount of money a company has saved over time, which can be reinvested into the business or given to shareholders.

On financial statements, a company can bring forward its retained earnings from one period to the next, letting the money accumulate over time.

How businesses use retained earnings

The way businesses use retained earnings is closely related to the company’s size and structure, as well as business goals.

For example, large public companies often balance reinvesting earnings with distributing dividends to attract and maintain investment. Such companies can also use these earnings to issue bonus shares, which can increase the share price and benefit investors.

In contrast, small businesses might primarily reinvest profits to drive growth. Investors typically understand that small businesses need time to grow, and don’t expect dividend payouts early on. Other than funding growth-focused projects, businesses might use their retained earnings to improve their capabilities, such as through equipment and software. These earnings can also provide a buffer when it’s difficult to secure external funding.

How to calculate retained earnings

Let’s look at an example of a coffee shop chain that posts $3 million in annual sales.

To calculate its retained earnings, first, subtract the various costs and taxes. Let’s assume these are:

• $1 million for variable costs, including employee wages and coffee beans

• $750,000 for fixed costs like rent and marketing

• $150,000 in taxes

After deducting the costs, the company has a net profit of $1.1 million. If the company decides to distribute $600,000 as dividends, it leaves $500,000 in retained earnings – which the business can reinvest into further expansion or enhancing its facilities.

Advantages of retained earnings

Retained earnings help businesses to:

Invest in expansion

Businesses focused on growth can use retained earnings to fund expansion, with long-term growth and profitability in mind. The idea is to use these profits to capitalise on growth opportunities that can generate more revenue in the long run, and in turn, higher dividends.

Create a safety net

There are ups and downs in any business, and it’s important to have a plan for a sudden downturn. If an initiative turns out to be less profitable than hoped or an unexpected expense arises, you could borrow money – but this can come with limits and costs. Having money in the bank provides security and doesn’t come with lenders’ fees, which is a significant advantage of retained earnings compared to other forms of financing.

Boost investor confidence

Retained earnings can indicate financial stability, which makes the business more attractive to current and potential investors, bringing in more funding.

Disadvantages of retained earnings

While retained earnings can serve businesses well in many ways, it could also create some limitations:

Opportunity cost

Consider where you can best put your retained earnings to work. You could invest them elsewhere for higher returns, such as in new projects, acquisitions, or other investment vehicles. When businesses retain earnings, rather than investing them, they might lose out on more attractive or lucrative investments.

Shareholder misalignment on how to use the retained earnings

Sometimes, stakeholders could disagree on what to do with retained earnings. This may be more common in large companies with more stakeholders, where differing opinions are more likely.

Some shareholders may see the wisdom in a company reinvesting money into growth and boosting stock prices. Others may be after shorter-term wins, and feel disappointed if they don’t receive regular payouts. Potential investors will also form their opinion of a company based on the dividend stream.

How much earnings should a company retain?

The answer to this question depends on your business’s unique needs.

Whether you choose to reinvest your retained earnings into growth or pay shareholder dividends boils down to several considerations, including your business’ financial obligations, short- and long-term goals, as well as risk appetite.

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Your retained earnings depend on the amount of net profit left at the end of the day. To increase retained earnings, you’ll need to increase profits, reduce costs, or both.

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