What is retained earnings: Advantages and disadvantages

Creating and selling products and services is just one part of running a successful business. Once the money starts flowing in, you need to decide how to allocate your revenue. If the business is publicly owned, do you pay out dividends, or do you keep the money in the business?

This decision can have a big impact on the long-term success of your business, and there are several factors to consider before making up your mind.  First, it’s important to understand the core terminology.

What are retained earnings?

Also known as ‘retained profits,’ ‘trading profits,’ or ‘earnings surplus,’ this is money held in the business, rather than paid out to shareholders. It’s a form of equity that is an important measure of a company’s financial stability, and one in which potential investors will be interested. 

It’s also a term that’s crucial to the field of accounting. On financial statements, a company can ‘bring forward’ its retained earnings from one period to the next, with the money accumulating over time.

Features of retained earnings

Retained earnings serve multiple roles in a business. They act as a security cushion, providing support during times when raising external funds may be challenging. Additionally, retained earnings may also be put towards internally funding more risky and innovative projects that may be capable of driving business growth but lack investor interest.

Finally, surplus retained earnings or profit can also be converted into ownership securities by issuing bonus shares, increasing share price for investors.

Understanding retained earnings and what it means for your business

Retained earnings gives you, the business owner, and investors a general overview of your business’s health. How retained earnings is utilised varies from business to business. Some options include distributing profits as dividends to shareholders or reinvesting in business assets like new computers or software.

Retained earnings impacts businesses of all sizes and structures differently. Large public companies balance reinvestment with shareholder dividends to attract investment, while small businesses typically reinvest earnings to fuel growth, as their investors generally do not expect immediate dividends. Businesses without shareholders focus on managing expenses and revenue, regardless of dividend obligations.

Example of retained earnings

To understand what retained earnings is in business, Let’s look at an example of a coffee shop chain that posts $3 million in annual sales. 

To calculate its retained earnings, we must first subtract 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, and $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 available for reinvestment into further expansion or enhancing store facilities.

What are the advantages of retained earnings?

Invest in expansion

A company that’s focused on growth may pay low or no dividends, because it makes more sense to finance expansion activities. The idea is that more money can be made for everyone (including shareholders) in the long run by using retained profits to capitalise on opportunities and grow the business. 

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 a certain initiative turns out to be less profitable than hoped or an unexpected expense arises, it may be possible to 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 profits compared to other forms of financing.

Boost investor confidence

Retained earnings means more money in the company’s coffers , which makes the business look like a more attractive prospect to potential investors. The balance sheet’s bigger; there’s more stability. This can raise the share price, and attract investment, which could create a virtuous cycle of growth.

What are the disadvantages of retained earnings?

Inefficiency

Early-stage companies may want to keep things simple, and only spend the money they already have. But for some businesses, borrowing might make more sense than relying on retained earnings. The average annualised return for the S&P 500 is more than 10%, so if your company can borrow at 5%, it could be a calculated risk worth taking. 

Look at Apple: its annual retained earnings in 2021 were $5.6B. In 2013, the figure was $116.6B. However, its stock price and market capitalisation has grown during that time.

Shareholder dissatisfaction

One of the disadvantages of retained earnings are the disagreements over what to do with it. This is especially true for large companies with many shareholders to please. 

Some shareholders may see the wisdom in a company reinvesting money and potentially boosting stock prices, leading to long-term growth. Others may be after shorter-term wins, and become disgruntled if they don’t receive regular payouts. Potential investors will be aware of the dividend stream, too, and it will affect their opinion of the company accordingly.

How much earnings should a company retain?

The answer to this question depends on everything that makes that business unique. What financial obligations does the company have? What are the goals, and are they long-term or short-term? What’s the appetite for risk?

Weigh the advantages and disadvantages of retained profit, and ask yourself these types of questions when making decisions about retained profits versus shareholder dividends. 

Boost earnings with an Airwallex business account

The amount of retained earnings a company keeps is affected not only by shareholder considerations, but by how much revenue is coming in and what costs are going out. 

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