Retained Earnings Explained for Dummies

What are retained earnings (RE)?

Retained earnings (RE) are the profits a company has generated and accumulated to a certain date, minus any dividends distributed to shareholders in the past. Put in other words, retained earnings are the portion of profits that a company reserves to use as working capital, capital expenditures, or to pay off debt obligations.  

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Formula to calculate retained earnings

The formula to calculate retained earnings (RE) at the end of a financial period, such as a financial year, is as follows: RE at end of financial period = RE at beginning of financial period + net profit for the period - Cash dividends - Stock dividends Where:

• Cash dividends are payments made by a company to shareholders in the form of cash (nowadays via electronic transfers).
• Stock dividends are additional shares issued by a company to its shareholders. Typically, a percentage of a shareholder’s equity.

Note: When a company suffered a net loss during a financial period, the net loss is deducted from the RE at the beginning of the period.  

Retained earnings reported on the balance sheet

In addition to share capital and net income, retained earnings are reported on the balance sheet under the shareholders’ equity section.  

Managing retained earnings

The management of a company is required to perform a fine balancing act when deciding how to administer the company’s retained earnings. On the one hand, the board of directors has to consider the interests and rights of the shareholders (owners). On the other hand, money available from retained earnings is necessary for the expansion and growth of the company. Usually, the management of a company maintains a balanced approach, distributing a fair number of dividends to shareholders and retaining enough of the earnings to be reinvested in activities such as:

• Expansion of operations

A portion of the retained earnings may be utilised to buy new equipment, upgrade a factory building, hire consultants to improve the marketing strategy or employ more staff to improve services to customers.

• Launching new products or services

The management of a company may decide to use retained earnings to finance a new product or service to increase the company’s list of what it can offer to its customers and to attract new customers.

• Paying off debt

A company may decide to pay off part or all of its debt, avoiding over-leveraging and enabling the company to reinvest in the expansion of activities.

• Merger, acquisition, or strategic partnership

Money from the retained earnings can be used for any possible merger, acquisition, or strategic partnership that will enhance the company’s position in the market, improve its infrastructure, and broaden its customer base.   A merger takes place when two entities, like companies, combine to form a new legal entity. A merger can be executed in one of the following ways:

• By closing both the old entities and forming a completely new one.
• When entity A integrates entity B. Put differently, one entity continues to operate while the other one ceases to exist.

An acquisition occurs when one company acquires control of another company, either via purchasing its shares or its assets. The acquiring can be done with cash, offering of shares, or a combination of the two. An acquisition is also called a takeover or a business acquisition. The company that acquires the other company is referred to as the acquiring company or the acquirer. The company that is the subject of acquisition is called the acquired or target company.  

Stakeholders who are interested in the retained earnings of a company

• Shareholders

As internal stakeholders, shareholders will benefit from favourable retained earnings figures, expecting to benefit from increased dividends or an increase in the share price of the company.

• Lenders

External stakeholders, such as lenders, look at a company’s retained earnings from a different viewpoint. Lenders are keen to be convinced that a company is able to honour its future debt obligations. Lenders want to be assured that the management of a company will retain enough earnings to avoid defaulting on its loans, reducing the lenders’ credit risk.  

Shortcomings of retained earnings

Analysts may not obtain any significant information from the reported retained earnings during a specific financial period, such as a quarter or financial year. Observing the changes in retained earnings over a specific period of time (for instance, three years) only indicates trends of how much money a company is adding to retained earnings and how much was spent on the distribution of dividends to shareholders. As investors, shareholders would like to know more about the returns the retained earnings have generated and if they were preferable to other types of investments.  

Financial ratios regarding retained earnings

The following financial ratios are used by analysts and shareholders to determine how effectively a company’s earnings are managed.

Dividend payout ratio (DPR)

The dividend payout ratio (DPR), sometimes called the payout ratio, measures the percentage of a company’s net income that is distributed to shareholders in the form of dividends during a specific financial period. Keep in mind, income that is not distributed to shareholders as dividends is reserved as a part of the company’s retained earnings. Formulas to calculate the dividend payout ratio:

• Dividend payout ratio = Total dividends/Net income

For example, the company Best of Luck reports a net income of R200 000 and pays R50 000 in dividends during the past financial year. The company’s DPR is determined as 25% ((R50 000/R200 000) x 100). The DPR of 25% implies that company Best of Luck paid 25% of its net income to shareholders and retained 75% of its net income, using it for primary operations or to pay off debt.

• The DPR can also be calculated on a per-share basis, using the following formula:

DPR = Dividend per share (DPS)/Earnings per share (EPS) Where:

• Dividend per share (DPS) is the total of dividends (interim and final dividends) declared and issued by a company over a specific financial period, usually a year. DPS is calculated by dividing the total dividends paid out by a company during a given financial period by the number of outstanding ordinary shares.
• Earnings per share (EPS) is a financial ratio that measures a company’s ability to generate net profits for its ordinary shareholders.

  The following two formulas are commonly used to calculate EPS: EPS = (Net income - Preference shares dividends)/End of period ordinary shares outstanding Or EPS = (Net income - Preference shares dividends)/Weighted average ordinary shares outstanding  

What does the dividend payout ratio signals?

Depending on the strategy and priorities of a company, the DPR is likely to vary significantly between different companies. A low DPR can relate that a company is reinvesting most of its earnings into operations that will enhance its growth. A high DPR can signal that the management of a company is more likely to reward shareholders for their investments in the company. However, if the DPR of a company exceeds 100%, it is an indication that the company is distributing more dividends than its income can support - a practice that cannot be sustained in the long term.  

Retained earnings-to-market value

A key indicator to determine how well a company’s retained earnings are managed is the retained earnings-to-market value. Typically, calculated over a given period of time (usually a number of years), the metric assesses the change in the share price of a company in relation to the net earnings retained by the company. For instance, a company’s share price increased from R45.50 in September 2016 to R80.20 in September 2026. During the five years, the total earnings per share (EPS) was R13.65, while the total dividend paid out by the company was R5.46 per share. To determine the net earnings, the R5.46 per share dividend paid out is deducted from the R13.65 EPS. Thus, net earnings per share is R13.65 - R5.46 = R8.09 per share, meaning the company retained a total of R8.09 per share over the period of five years. During the five years, the company’s share price increased by R34.70 (R80.20 - R45.50). Dividing the rise in the share price by net earnings retained per share gives an answer of R4.29 (R34.70/R8.00), indicating that for each South African rand (ZAR) of retained earnings, the company was able to create R4.29 worth of market value.  

What are negative retained earnings?

When the net loss suffered by a company in a financial year exceeds the balance of retained earnings at the start of the financial year, the company reports negative retained earnings. Negative retained earnings can have several negative impacts on a company, such as:

• It can reduce the total number of shareholders’ equity.
• It may be a sign that expenses are too high.
• It may be an early warning that a company is staring serious financial troubles in the face, including bankruptcy.

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