The Importance of Retained Earnings

By Stock Research Pro • June 9th, 2009

Retained earnings, also known as “accumulated earnings” or “retained capital” refer to the portion of net income the company retains as opposed to distributing those funds to shareholders in the form of dividends. A company’s retained earnings are typically reinvested into its core business or used to pay down debt. A company’s retained earnings (or retained losses) are cumulative from year to year with losses and earnings offsetting and reported in the company’s Statement of Retained Earnings/ Losses.

Calculate Retained Earnings

The formula to calculate retained earnings can be written as:

Retained Earnings = Beginning Retained Earnings + Net Income – Dividends

The formula simply adds net income for the period (or subtracts a loss) from the beginning retained earnings and then deducts any dividends paid for the period.

Interpreting Retained Earnings

Reinvestment of retained earnings can be an important source of financing for many companies. Many creditors will closely monitor a company’s retained earnings statement because the company’s policy regarding dividend payments to its stockholders can have a direct impact on its ability to repay its debt.

The importance of retained earnings to investors is in understanding the level to which the company reinvests its earnings to fund growth and expansion. If, however, the company reinvests retained earnings without demonstrating significant growth, investors would probably be better off if the company had issued a dividend.

The Statement of Retained Earnings

The Statement of Retained Earnings or Statement of Owner’s Equity is a basic financial statement issued by a company to outline the changes in the company’s retained earnings over the reporting period. Using net income for the period and other company financial statements, the statement reconciles the beginning and ending retained earnings for the reporting period. The statement of retained earnings uses information from the income statement and provides information to the balance sheet.

The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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