Negative retained earnings can be a concerning issue for any company, as they indicate that it has consistently reported net losses over time. This can lead to a decrease in shareholder confidence and potentially make it more difficult for the company to obtain financing in the future.
The potential implications of a negative retained earnings balance depend on the severity and duration of the losses. In the short term, negative retained earnings may decrease shareholder confidence and make it more difficult for the company to obtain financing. In the long term, negative retained earnings may indicate that a company is not financially viable and may lead to its eventual failure.
To understand negative retained earnings, it's best if we define what it is and how it affects your business.
What are retained earnings?
Retained earnings (sometimes called accumulated earnings) are the portion of a company's profits that are not distributed to shareholders in the form of dividend payments but are kept by the company to be reinvested in the business or used to pay off debts.
The retained earnings account is a component of the shareholder's equity section of the balance sheet. This is a vital component of a company's financial health and long-term viability, as it can provide the company with resources to fund growth, make investments in its operations, or pay off debts. It can also be an essential factor in a company's creditworthiness, demonstrating its ability to generate profits and set them aside for future use.
Before calculating retained earnings, the first step is to find the retained earnings balance from a previous accounting period. Then add or subtract any net income or net loss for the new period and any dividends that were paid during the period.
The retained earnings formula is:
Retained Earnings = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends
Here is an example of how to calculate retained earnings:
Starting retained earnings: $1,000,000
Net income for the period: $250,000
Dividends paid during the period: $75,000
Retained earnings = Starting retained earnings + Net income - Dividends paid
Retained earnings = $1,000,000 + $250,000 - $75,000
Retained earnings = $1,175,000
In this example, the company has retained earnings of $1,175,000 at the end of the period.
While positive retained earnings are ideal, your retained earnings can still be harmful, depending on whether or not the company has generated more profits than it has paid out as dividends.
What are negative retained earnings?
Negative retained earnings (also known as accumulated deficit) refers to a situation in which the profits owned by a company have not been sufficient to offset losses over a given time. In other words, it means that the company has experienced a loss in terms of total net income.
Negative retained earnings can be interpreted in several ways. If the company is just starting out, it's not uncommon that operating costs and investments might outweigh net income.
Companies focused on growth may be more likely to incur losses due to the risks associated with expanding into new markets or introducing new products or services. Additionally, growing companies may intentionally operate in such a way that results in negative retained earnings. They may invest heavily in research and development, marketing, and other activities necessary for expansion but may not immediately generate profits.
This isn't necessarily a bad thing. If a company is truly growing and has a path toward sustainable revenue, then, by all means, it should be spending as much as it can on outpacing its competitors.
If you're investing in growth stocks or tech startups, recognize that retained earnings don't provide the full picture. It may be worth looking into other financial metrics to determine whether they are acting fiscally responsible.
For established companies that already have a defined business model and aren't focussing on innovation or R&D, negative retained earnings may signal an issue.
If you're a value investor, you'll likely want to stay away from companies with negative retained earnings. Ask yourself, will they be able to pay dividends next year?
Is negative retained earning a debt?
Negative retained earnings are not considered debt in the traditional sense, as they do not represent an obligation that a company owes to a creditor. Instead, they represent a company's accumulated losses that profits have not offset.
Negative retained earnings impact a company's ability to pay out dividends. They can be a red flag for investors, as they may indicate that the company is struggling financially and may not be able to generate sufficient profits in the future. Negative retained earnings can also limit a company's ability to pay dividends to shareholders or make investments in the business.
Some people argue that negative retained earnings are a form of debt because they represent an obligation of the company to its shareholders. According to this view, the company is required to make up for the losses it has incurred in the past and pay back the shareholders for their investment.
However, negative retained earnings should not be considered debt because they do not involve a promise to pay back a specific amount of money to a particular creditor.
Why would a company have negative retained earnings?
When a company has negative retained earnings, it means that the company's losses are more significant than its accumulated profits. This can concern investors and creditors, as it may indicate that the company is in financial distress.
The most obvious reason for negative retained earnings is a lack of profitability. If a company is not generating enough profits to cover its expenses, it will eventually accumulate losses and end up with negative retained earnings. This can be caused by a variety of factors, such as increased competition, changing market conditions, or inefficient operations.
Another common cause of negative retained earnings is high expenses. If a company is spending more money than it is bringing in, negative retained earnings are inevitable. This can be caused by various factors, such as overstaffing, high rent or lease payments, excessive advertising expenses, or poor management.
External factors, such as economic downturns or natural disasters, can also contribute to negative retained earnings. If a company is affected by external factors beyond its control, it may struggle to generate profits.
It's important to note that negative retained earnings do not necessarily mean that a company is failing. Some companies may incur losses in their operations' early stages but can profit. In these cases, the negative retained earnings can be considered a normal part of the business cycle.
Still, it is essential for a company to actively work to turn its negative retained earnings around by implementing strategies to increase profits and reduce losses.
How do you get rid of negative retained earnings?
Again, negative retained earnings do not necessarily mean a company's end. There are various methods that a company can use to recover and get back on track. Here are a few strategies to consider:
Cut costs:
One of the most effective ways to recover from negative retained earnings is to reduce expenses. This can involve cutting unnecessary costs, such as travel, hiring, etc. It may also include negotiating lower prices with suppliers or outsourcing certain tasks to reduce labor costs.
Increase revenue:
Another way to recover from negative retained earnings is to increase revenue by finding new customers or selling more to existing customers. This can involve expanding into new markets, launching new products or services, or increasing marketing efforts to bring in more business.
Raise capital:
If the company's financial situation is dire, it may be necessary to raise capital by taking on additional debt or seeking additional investments from venture capitalists or angel investors.
Restructure the business:
In some cases, a company's negative retained earnings may result from underlying problems with the business model or operations. In these cases, it may be necessary to restructure the business to align with market demand and improve efficiency. This could involve changing the business model, reorganizing the company, or streamlining processes to reduce costs.
Seek professional help:
If a company is struggling to recover from negative retained earnings, it may be helpful to seek the advice of a financial professional or turnaround expert. These individuals can provide valuable insights and guidance on how to get the company back on track.
Recovering from negative retained earnings is not easy, but it is possible with the right approach and willingness to make tough decisions. By following these strategies and seeking professional help, companies can get back on track for long-term success.
Conclusion
Negative retained earnings can be a concerning issue for a company, as it indicates that the company has consistently reported net losses over time. This can lead to a decrease in shareholder confidence and potentially make it more difficult for the company to obtain financing in the future. In order to address negative retained earnings, the company will need to take steps to improve its financial performance and generate profits. This may involve implementing cost-cutting measures, expanding into new markets, or introducing new products or services. The company needs to communicate with its shareholders and provide regular updates on its financial performance and plans for improvement.
The key to addressing negative retained earnings is to focus on long-term sustainability and profitability. With careful planning and strategic decision-making, a company with negative retained earnings may be able to turn its financial situation around and build a stronger foundation for future growth.
