Definition
Retained earnings are the cumulative amount of net income earned by a company that is retained within the business rather than being paid out as dividends to shareholders. These earnings are reinvested to support the company’s operations, pay down debt, purchase assets, or fund expansions. Retained earnings are reported in the equity section of the company’s balance sheet and are a key indicator of a company’s financial health and capacity for growth.
Examples
- Startup Company: A startup tech company might retain earnings to invest in research and development (R&D) to enhance its product offerings, leading to future growth.
- Manufacturing Firm: A manufacturing company might retain earnings to upgrade machinery and improve efficiency, ultimately reducing costs and increasing profitability.
- Retail Chain: A retail chain might retain earnings to open new store locations, thereby expanding its market presence and sales potential.
Frequently Asked Questions (FAQs)
The formula for calculating retained earnings is:
\[ \text{Retained Earnings} = \text{Beginning Retained Earnings} + \text{Net Income} - \text{Dividends Paid} \]
Why are retained earnings important?
Retained earnings are essential as they provide internal financing for a company’s growth without the need to raise external capital. They reflect the company’s ability to generate profit and reinvest it efficiently.
Can retained earnings be negative?
Yes, retained earnings can be negative if a company has incurred more losses than profits over time. Negative retained earnings are often referred to as an accumulated deficit.
How do retained earnings affect a company’s stock price?
Retained earnings can positively impact a company’s stock price by enabling the company to reinvest in growth opportunities, thereby potentially increasing future revenues and earnings.
Are retained earnings the same as revenue?
No, retained earnings are not the same as revenue. Revenue is the total income earned by a company from its operations, while retained earnings are the portion of net income that is reinvested in the business after accounting for dividends.
Dividend:
A dividend is a distribution of a portion of a company’s earnings to its shareholders as decided by the board of directors.
Balance Sheet:
A balance sheet is a financial statement that reports a company’s assets, liabilities, and shareholders’ equity at a specific point in time.
Net Income:
Net income is the total profit of a company after all expenses, including taxes and operating costs, have been deducted from total revenue.
Shareholders’ Equity:
Shareholders’ equity represents the net value of a company, computed as total assets minus total liabilities. It reflects the owners’ residual interest in the company.
Online References
- Investopedia: Retained Earnings
- Corporate Finance Institute: Retained Earnings
- Accounting Coach: Retained Earnings
Suggested Books for Further Studies
-
“Financial Accounting” by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso
This book provides a comprehensive overview of financial accounting concepts, including detailed explanations of retained earnings.
-
“Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen
This book explores the fundamentals of corporate finance, including topics related to retained earnings and their impact on corporate growth.
Accounting Basics: “Retained Earnings” Fundamentals Quiz
### What are retained earnings?
- [ ] Total revenue earned by a company.
- [x] The portion of net income not paid out as dividends.
- [ ] The amount paid to shareholders.
- [ ] Taxes withheld from employees' salaries.
> **Explanation:** Retained earnings refer to the portion of net income that is retained in the business and not distributed as dividends to shareholders.
### How is the beginning retained earnings balance adjusted?
- [ ] With total revenue.
- [x] With net income and dividends paid.
- [ ] Only with total expenses.
- [ ] With gross profit.
> **Explanation:** The beginning retained earnings balance is adjusted by adding net income and subtracting dividends paid during the period.
### Can retained earnings be negative?
- [x] Yes, if accumulated losses exceed profits.
- [ ] No, they always remain positive.
- [ ] Only if dividends aren't paid.
- [ ] Only in the first year of operations.
> **Explanation:** Retained earnings can be negative if a company has accumulated more losses than profits over time, resulting in an accumulated deficit.
### Where are retained earnings reported?
- [ ] On the income statement.
- [ ] On the cash flow statement.
- [x] In the equity section of the balance sheet.
- [ ] On the tax returns.
> **Explanation:** Retained earnings are reported in the shareholders' equity section of the balance sheet.
### What effect do retained earnings generally have on a company's growth?
- [x] Positive, by providing internal funding for investments.
- [ ] Negative, by causing increased liabilities.
- [ ] Neutral, with no effect.
- [ ] Unpredictable, varies greatly.
> **Explanation:** Retained earnings typically have a positive effect on a company's growth as they provide internal funds for reinvestment in business operations.
### How can retained earnings impact a company's stock price?
- [x] By enabling reinvestment in growth opportunities, potentially increasing stock price.
- [ ] By causing dilution of shares.
- [ ] By increasing dividend payout ratios.
- [ ] By causing immediate revenue increase.
> **Explanation:** Retained earnings can lead to reinvestment in growth opportunities, thereby potentially increasing future earnings and the company's stock price.
### What is the primary purpose of retaining earnings within a company?
- [ ] To increase short-term cash flow.
- [ ] To pay off current liabilities immediately.
- [x] To fund growth and expansion, reduce debt, or improve operations.
- [ ] To increase the sales revenue directly.
> **Explanation:** The primary purpose of retaining earnings within a company is to fund growth and expansion, reduce debt, or improve operations.
### Which statement accurately describes the relationship between retained earnings and dividends?
- [ ] Retained earnings are distributions to shareholders.
- [x] Dividends are distributions that reduce retained earnings.
- [ ] Dividends increase retained earnings.
- [ ] Retained earnings determine the interest rate on dividends.
> **Explanation:** Dividends are distributions made to shareholders and are subtracted from retained earnings.
### What essentially do negative retained earnings indicate about a company's financial history?
- [ ] The company has paid high dividends.
- [x] The company has accumulated more losses than gains over time.
- [ ] The company has high revenue.
- [ ] The company has issued many shares.
> **Explanation:** Negative retained earnings, or an accumulated deficit, indicate that the company has incurred more losses than profits historically.
### What financial statement reflects retained earnings most prominently?
- [ ] Income statement.
- [ ] Cash flow statement.
- [ ] Statement of retained earnings.
- [x] Balance sheet.
> **Explanation:** Retained earnings are reflected most prominently in the balance sheet under shareholders' equity.
Thank you for engaging with our detailed explanation of retained earnings, reinforcing your learning with our quiz questions, and continuing to expand your accounting knowledge!
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