What Retained Earnings Tells You

Whenever a company generates surplus income, a portion of the long-term

shareholders may expect some regular income in the form of dividends as a
reward for putting their money in the company. Traders who look for short-term
gains may also prefer getting dividend payments that offer instant gains.

Dividends are also preferred as many jurisdictions allow dividends as tax-free

income, while gains on stocks are subject to taxes. On the other hand, company
management may believe that they can better utilize the money if it is retained
within the company. Similarly, there may be shareholders who trust the
management potential and may prefer allowing them to retain the earnings in
hopes of much higher returns (even with the taxes).

KEY TAKEAWAYS
The following options broadly cover all possibilities on how the surplus money
can be utilized:

 The income money can be distributed (fully or partially) among the

business owners (shareholders) in the form of dividends.
 It can be invested to expand the existing business operations, like
increasing the production capacity of the existing products or hiring more
sales representatives.
 It can be invested to launch a new product/variant, like a refrigerator maker
foraying into producing air conditioners, or a chocolate cookie
manufacturer launching orange- or pineapple-flavored variants.
 The money can be utilized for any possible merger, acquisition, or
partnership that leads to improved business prospects.
 It can also be used for share buybacks.
 The earnings can be used to repay any outstanding loan (debt) the
business may have.

The first option leads to the earnings money going out of the books and accounts
of the business forever because dividend payments are irreversible. However, all
the other options retain the earnings money for use within the business, and such
investments and funding activities constitute the retained earnings (RE).

By definition, retained earnings are the cumulative net earnings or profits of a

company after accounting for dividend payments. It is also called earnings
surplus and represents the reserve money, which is available to the company
management for reinvesting back into the business. When expressed as a
percentage of total earnings, it is also called retention ratio and is equal to (1 -
dividend payout ratio).
While the last option of debt repayment also leads to the money going out, it still
has an impact on the business accounts, like saving future interest payments,
which qualifies it for inclusion in retained earnings.

Management and Retained Earnings

The decision to retain the earnings or to distribute it among the shareholders is
usually left to the company management. However, it can be challenged by the
shareholders through majority vote as they are the real owners of the company.

Management and shareholders may like the company to retain the earnings for
several different reasons. Being better informed about the market and the
company’s business, the management may have a high growth project in view,
which they may perceive as a candidate to generate substantial returns in the
future. In the long run, such initiatives may lead to better returns for the company
shareholders instead of that gained from dividend payouts. Paying off high-
interest debt is also preferred by both management and shareholders, instead of
dividend payments.

Most often, a balanced approach is taken by the company's management. It

involves paying out a nominal amount of dividend and retaining a good portion of
the earnings, which offers a win-win.

Dividends and Retained Earnings

Dividends can be distributed in the form of cash or stock. Both forms of
distribution reduce retained earnings. Cash payment of dividend leads to cash
outflow and is recorded in the books and accounts as net reductions. As the
company loses ownership of its liquid assets in the form of cash dividends, it
reduces the company’s asset value in the balance sheet thereby impacting RE.

On the other hand, though stock dividend does not lead to a cash outflow, the
stock payment transfers a part of retained earnings to common stock. For
instance, if a company pays one share as a dividend for each share held by the
investors, the price per share will reduce to half because the number of shares
will essentially double. Since the company has not created any real value simply
by announcing a stock dividend, the per-share market price gets adjusted in
accordance with the proportion of the stock dividend.

While the increase in the number of shares may not impact the company’s
balance sheet because the market price automatically gets adjusted, it
decreases the per share valuation, which gets reflected in capital accounts
thereby impacting the RE.
A growth-focused company may not pay dividends at all or pay very small
amounts, as it may prefer to use the retained earnings to finance activities like
research and development, marketing, working capital requirements, capital
expenditures and acquisitions in order to achieve additional growth. Such
companies have high RE over the years. A maturing company may not have
many options or high return projects to use the surplus cash, and it may prefer
handing out dividends. Such companies have low RE.