The Meaning of Retained Earnings
A company’s profit can be used in a variety of ways. Here are some of those options.
Since dividends are irreversible, the first option permanently removes earnings money from the organization’s books.
All other options constitute retained earnings (RE), including investing in or funding an active business.
Dividends (in full or in part) may be paid to shareholders when the business earns income.
If the investment is used for business expansion, such as hiring more salespeople or boosting production, it can increase business operations.
It is possible to launch new products and varieties; for example, an air conditioning company can make pineapple- or orange-flavored air conditioners, or a chocolate cookie company can create orange- or pineapple-flavored cookies.
The money may be used for mergers, acquisitions, or partnerships to improve business prospects.
It can also carry out share buybacks with it.
Any outstanding loans which the business may owe can be repaid using the earnings.
Thus, retained earnings are the profits or earnings that remain after dividends are paid out. As a result of the earnings surplus, the company can invest it back into the business. Retention ratios are usually expressed as a percentage of total earnings and are known as dividend payout ratios.
Though debt repayment is also a method of eliminating cash from the organization, it influences its accounting.
In the case of profits, there is plenty of room for the company management or the business owner(s) to manage the surplus money.
Retained Earnings and Management
The decision to retain earnings or distribute them among shareholders is usually left up to company management. A majority vote can challenge the ownership of a company’s shares, which constitute its actual owners.
Shareholders and management may want to keep earnings for a variety of reasons. As a result of better knowledge of the market and the companyâ€™s operation, the management may have spotted a project that provides substantial returns in the future. Shareholders may gain higher profits from these types of projects than they get from dividend payments in the long run. Furthermore, shareholders and management may prefer to pay down high-interest debt to avoid paying dividends. A long-term shareholder may expect a regular dividend income when surplus income is generated to reward their investment. In addition to long-term investors, short-term traders are attracted to dividends that offer immediate gains. Management tends to approach most situations from a balanced perspective. The company pays dividends and retains earnings, making it a win-win.
Retained Earnings vs. Dividends
Dividends can also be paid in the form of stock dividends. Retained earnings will be reduced both ways. In the books and accounts, dividend payments are classified as cash outflows because they reduce cash. Due to the reduction in asset value, cash dividends harm RE.
Alternatively, part of the retained earnings is transferred to common stock without leaving cash on the balance sheet with a stock payment. For example, a dividend of one share per share owned by an investor will reduce the share price by half since the number of shares will be essentially doubled. Because there is no real value created by simply announcing a stock dividend, the per-share market price is adjusted based on the proportion of the dividend. Changes in the share count will not affect the balance sheet because the stock price is automatically adjusted with the increase in the share count. However, the decrease in the per-share valuation will impact the RE since it is reflected in the capital accounts. Businesses pursuing growth may not pay dividends at all or may only pay extremely small amounts to invest in activities like marketing, research and development, and working capital to achieve extra growth. Over the years, such companies have accumulated a large amount of retained earnings. It may be more advisable to invest dividends rather than surplus cash of a maturing company. Companies of this type have low returns on equity.
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