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Statement of Retained Earnings: Definition – Explanation – Example

What Is a Statement of Retained Earnings?

Statement of Retained EarningsA statement of retained earnings shows the accumulated portion of a business’s profits that are not distributed as dividends to shareholders. The retained earnings statement is a financial disclosure that shows how a company’s retained earnings have changed over time. Analysts use this statement to understand how business profits are utilized.  They do this by reconciling the beginning and ending retained earnings for the period.  Also, by using information such as net income from other financial statements.

The statement of retained earnings is also known as an equity statement.  Other names are a statement of owner’s equity or a statement of shareholders’ equity. There are boilerplate templates for the statement of retained earnings available online. It is developed using generally accepted accounting concepts (GAAP).

Statement of Retained Earnings – A Closer Look

This statement of retained earnings can be presented alone or as part of a balance sheet or income statement. The disclosure is a financial record that includes valuable information about a company’s current status.  For example, retained earnings,  net income, and dividends paid to stakeholders. Also, any amount that is set aside to manage specific obligations outside of shareholder dividend payments.  Moreover, any amount designated to offset losses is referenced in an organization’s net income. Each statement covers a specific time period which is clearly listed in the disclosure.

The statement of retained earnings serves as a transition from the income statement to the balance sheet. It indicates any earnings after-tax deductions such as dividends paid to shareholders. The net amount left over is calculated and displayed. This sum is retained by the company and is accounted for on the balance sheet.  A running total continually adds it to the retained earnings account. Thus, the statement illustrates the changes in the retained earnings account between the beginning and closing balance sheet periods.

Statement of Retained Earnings – Why It Matters

A statement of retained earnings can provide useful information to financial professionals.

  • Investment decisions – The statement of retained earnings can assist investors in making critical decisions such as whether to buy, sell, or hold stocks. For example, if an investor observes significant retained earnings, they may expect the firm to grow in the coming period, which may influence their decision to purchase more stock.
  • Evaluate company management – Stockholders and other interested parties might utilize retained earnings to evaluate the success of the company. This is useful when making decisions about the board of directors or potential mergers.
  • Benchmark growth and performance – The statement of retained earnings focuses on the change between periods.  As a result, it can be used to track and assess growth. Each quarter or year, businesses can examine their own retained earnings. They might also compare them to other similar companies to evaluate how they stack up against the competition.

What Are Retained Earnings?

Retained earnings are also known as accumulated earnings or cumulative retained earnings. They are funds that are frequently utilized to repay debt payments.  Or, they are reinvested in the company to support growth and development. When a firm earns a profit, a portion of its long-term shareholders may receive regular income in the form of dividends.  This shared profit is essentially a reward for investing in the company. Traders seeking short-term share price appreciation may also enjoy dividend payments that provide immediate cash profits. Dividends are paid from profits, which reduces the company’s retained earnings.

The following options represent some of the alternatives for utilizing surplus money.  Retained earnings refer to any profits made by an organization that it keeps for internal use. These possibilities exist when funds are assigned to retained earnings and not given out as dividends:

  • Internal funding for growth – Funds can be used to expand current business operations.  For example,  increasing the manufacturing capacity, R&D, or expanding the sales force.
  • New product launch – Funds can be used to launch a new product or variant. For example, a bicycle manufacturer expanding into a motorized version.  Or, a donut producer introducing small cakes and pastries.
  • Mergers and acquisitions – The funds can be used for any potential merger, acquisition, or partnership that will result in increased business prospects.
  • Stock buyback – The company can purchase its own company shares on the open market.  This reduces the number of shares in circulation and usually drives up the share price.
  • Pay down outstanding debt – The earnings can be used to repay any outstanding loans the business may have. This saves money that would have been spent on interest.  Also, it avoids the effects of negative debt leverage.

Dividends and Retained Earnings

Dividend payments to shareholders can be made as either cash or stock. Both versions have the potential to lower the value of retained earnings for the business.

  • Cash dividends are a cash outflow that is reflected in the cash account as a reduction. As a result, the size of a firm’s balance sheet and the asset value are reduced.  This is because the corporation no longer owns a portion of its liquid assets.
  • Stock dividends do not necessitate a financial outflow. Instead, a portion of the RE is reallocated to common shares and additional paid-in capital accounts. This allocation has no effect on the overall size of the company’s balance sheet.  However, it dilutes the number of shares outstanding thereby, lowering the overall value of stocks per share.

Benefits of a Statement of Retained Earnings

The release of a statement of retained earnings is intended to boost market and investor trust in the business. Moreover, it is used as a metric to assess a company’s health. Retained earnings are not simply surplus funds. Instead, the retained revenues are redirected, frequently as internal reinvestment. In general, the retained earnings of a capital-intensive industry or company during a growth period will be higher.  This is in comparison to companies that are less intensive or stable and mature.

This can be due to a higher portion of the funds being channeled toward asset development. Also, because of differences in the emphasis on new product development.  For example, a technology-based corporation may have greater asset development needs than a small grocery chain. A grocery store can stay almost unchanged for a long time.  However, a computer tablet or smartphone requires more frequent innovation to be competitive in the market. As a result, the technology firm is likely to have more retained earnings than the grocery chain.

The statement of retained earnings displays how management decides to redirect a company’s retained earnings. This is a significant advantage to potential investors and shareholders alike. It reveals if funds are being dedicated to the acquisition of more assets.  Or, whether they are being distributed to investors in the form of dividend payments. As a result, it can provide a broad indication of how management intends to spend excess funds going forward.

The Retention Ratio

The retention ratio is one piece of financial information that may be derived from the statement of retained earnings. The retention ratio or plow back ratio is the percentage of earnings that are retained in the business. It is the percentage of net profits maintained to grow the business rather than distributed as dividends. As a result, it is the inverse of the payout ratio.  The payout ratio measures the percentage of profit distributed to shareholders in the form of dividends.  The retention ratio informs investors about how much money a company keeps to reinvest in its operations. Earnings growth may suffer if a corporation distributes all of its retained earnings as dividends.  This is as opposed to reinvesting them back into the business.

A company that is not successfully utilizing its retained earnings is more likely to incur extra debt.  Moreover, they may be required to issue new equity shares to fund expansion. As a result, the retention ratio assists investors in determining a company’s pace of reinvestment. Companies that hoard too much profit may not be spending their capital properly.  Often, they are better off if the money is spent on new equipment, technology, or expanding product lines. Dividends are often not paid by new firms because they are still expanding and require funds to do so. Conversely, established businesses can distribute a portion of their retained earnings as dividends.  They can do this while simultaneously reinvesting a portion back into the business.

Up Next: What Is a Section 83(b) Election?

83(b) ElectionA Section 83(b) election is a request that the IRS recognizes income and levy income taxes on acquired company shares at the time they are granted rather than later when they are vested. The 83(b) election is a provision of the Internal Revenue Code (IRC).  It allows an employee or startup founder to pay taxes on the fair market value of restricted company stock.  However, taxes are calculated at the time the stock is granted rather than the time it is fully vested.

When you make an 83(b) election, you ask the IRS to record income and collect income taxes on the acquisition of company shares when they are given, rather than later when they vest. The grant date is the day on which an employee receives a stock or stock options reward from the corporation. Vesting signifies that an employee has achieved actual ownership of the company’s shares or stock options.  Usually, this is done by completing a specified time period of working.

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