Question and Answer: Retained Earnings
What is RETAINED EARNINGS and how does it affect your small business?
Retained earnings refers to that part of a company’s net profit after taxation, which are retained in the business after payment of dividend (if there is any). Retained earnings has the effect of providing a cushion for the company to survive in case of adversity. The retained earnings also add to the value of share of a company thereby increasing the SHAREHOLDERS’ FUND.
HOW IT WORKS (EXAMPLE):
Let’s assume Sharon Resources Limited has been around for five years. During this time, it reported the following net income:
Year 1: N10,000,000
Year 2: N5,000,000
Year 3: -N5,00,0000
Year 4: N1,000,000
Year 5: -N3,000,000
Assuming Sharon Resources Limited paid no dividends during this time. Sharon’s retained earnings equal the sum of its net profits since inception, or in this case, N8,000,000. In subsequent years, Sharon’s retained earnings will change by the amount of each year’s net income, less dividends.
The retained earnings statement summarizes changes in retained earnings for a fiscal period, and total retained earnings appear in the shareholders’ equity portion of the balance sheet. This means that every Naira of retained earnings means another Naira of shareholders’ equity or net worth.
A company’s board of directors may appropriate some or all of the company’s retained earnings when it wants to restrict dividend distributions to shareholders. Appropriations are usually done at the board’s discretion, this is when the board of directors decide to set a certain portion of the retained earnings aside for the purpose of dividend.
WHY IT MATTERS:
It is important to understand that retained earnings do not represent surplus cash or cash left over after the payment of dividends. Rather, retained earnings demonstrate what a company did with its profits; they are the amount of profit the company has reinvested in the business since its inception. These reinvestments are either asset purchases or liability reductions.
Retained earnings somewhat reflect a company’s dividend policy, because they reflect a company’s decision to either reinvest profits or pay them out to shareholders. Ultimately, most analyses of retained earnings focus on evaluating which action generated or would generate the highest return for the shareholders.
Most of these analyses involve comparing retained earnings per share to profit per share over a specific period, or they compare the amount of capital retained to the change in share price during that time. Both of these methods attempt to measure the return management generated on the profits it ploughed back into the business.
Capital-intensive industries and growing industries tend to retain more of their earnings than other industries because they require more asset investment just to operate. Also, because retained earnings represent the sum of profits less dividends since inception, older companies may report significantly higher retained earnings than identical younger ones. This is why comparison of retained earnings is difficult but generally most meaningful among companies of the same age and within the same industry, and the definition of “high” or “low” retained earnings should be made within this context.