What affects retained earnings? Several factors can affect the retained earnings of a company by either increasing it or decreasing it. These factors include whether or not the company pays its shareholders dividends, net income, and net loss.
Before we properly discuss the factors that affect retained earnings, let us understand what it is.
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What is retained earnings?
Retained earnings are the portion of a business corporation‘s profits or net income that is left over after paying all its income taxes, direct and indirect costs, and dividends to shareholders. It is all the accumulated profits which the company has not spent.
Instead of spending all the profits made by a company to take care of recurrent expenditures and pay dividends to shareholders, the part of the profit that is kept by the company (retained earnings) serves as an internal source of long-term financing.
As such, instead of always seeking for debt or other external funding sources for projects, the company can fund its projects from its retained earnings.
In most instances, companies use their retained earnings to reinvest in the business through the purchase of new equipment, expansion to new markets, research and development (R&D) of products, services, or processes, business development, and marketing.
Retained earnings can also be used for debt repayment and future dividend payments. It can also be used to increase production capacity, hire new talents, and share buybacks.
When retained earnings are accumulated year after year, they are commonly referred to as accumulated profits. Retained earnings are usually recorded under the equity section of the company’s balance sheet.
Financial analysts and investors often examine a company’s retained earnings as a pointer to its financial health, potential for long-term growth, and ability to generate consistent profits over time.
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Does net income affect retained earnings?
Yes, the net income of a company affects its retained earnings because it is a major contributor to it. A company’s net income represents its total revenue after all expenses including tax have been deducted.
For companies that do not pay dividends, their annual net income usually gets added to their retained earnings thereby increasing it. Companies that pay dividends to their shareholders usually subtract these dividends from their net income and whatever is left over gets added to the retained earnings.
In both scenarios, provided that some portion of the net income gets saved by the company, it will positively affect the retained earnings by increasing it.
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Which three items affect retained earnings?
The three items that affect a company’s retained earnings are its net income, dividend payment, and net loss. Each of these items affects retained earnings differently by either increasing or decreasing it.
Factors that affect retained earnings
- Net income
- Shareholder dividends
- Net loss
Net income
The net income of an entity is one of the major factors that directly affect its retained earnings. Net income comprises a company’s leftover revenue after payment of all expenses such as fixed costs, taxes, and variable costs.
Retained earnings are directly affected by an increase or a decrease in net income hence any factor that affects net income indirectly affects retained earnings.
For example, when the cost of recurring expenses such as rent, salaries, and utility bills increase, the net income of the company will decrease since these payments are made from the revenue generated by the company. This will in turn reduce the money that can be retained by the company.
On the other hand, when the cost of goods sold such as the cost of raw materials and other direct labor costs get reduced mostly due to the company’s ability to source raw materials and labor from a cheaper source, it reduces the company’s expenditure thereby increase its net income and consequently, its retained earnings.
Therefore, most businesses that have robust retained earnings rely on their ability to generate more revenue through the provision of goods or the rendering of services while keeping their expenditure at the minimum level possible.
By so doing, they often achieve a cost leadership advantage in their industry while having more net income that can be channeled toward increasing their retained earnings.
Shareholder dividends
The payment of dividends is an additional factor that has an impact on a company’s retained earnings. Generally, investors who buy the stock of a company expect a return on their investment in the form of dividends.
The dividends received by investors vary in amount and frequency based on the company from which they buy the stocks. Some companies pay dividends at the end of every quarter but the most common practice is the annual payment of dividends at the end of each fiscal year.
However, some companies, especially startups, do not pay dividends at all, instead, they save all their income as a means of having an internal source of funding for future projects or the purchase of either tangible or intangible assets.
When companies pay dividends to their investors, the amount spent is typically taken out of the current net income of the company or from previous retained earnings. Hence, when shareholders receive dividends, the company’s retained earnings are reduced.
Net loss
Another factor that affects the retained earnings of a company is when the company experiences a net loss. This could result when the revenue from the sale of goods or services is not sufficient to cover the expenses of the company.
For instance, if a company generates a revenue of $1,000,000 but its expenditures such as the cost of goods sold, rent, and other operating expenses amount to $1,100,000. It indicates that the company has a net loss of $100,000.
Since the revenue generated cannot offset the expenses, it means the company has a net loss. Usually, this net loss is paid for from the previous retained earnings of the company. Thus, a net loss will usually result in a decrease in a company’s retained earnings.
Companies that consistently record a net loss may have to file for bankruptcy especially when they no longer have any retained earnings to cover their expenses. That is why most investors consider a company’s retained earnings before investing in it. This is because it can be used as a metric to determine the financial health of the company as well as its profitability.
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What causes retained earnings to decrease?
The retained earnings of a company decrease when it consistently pays dividends to its shareholders or incurs more expenses than revenue. This generally involves spending all net income on dividends or paying a high price for raw materials, payroll, and other recurrent expenses.
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What causes retained earnings to increase?
Retained earnings increase when a brand has been able to successfully scale its business and remains profitable over the years. This is often achieved by making profits from the provision of services or the sale of goods. It also includes getting additional paid-in capital from the sale of the company’s shares.
Additionally, if the company has maintained a culture of saving part of its net income as retained earnings without spending it on capital investments or dividend payments, the company will have a robust retained earnings account balance due to the compounding effect of the quarterly or yearly additions to the retained earnings.
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Conclusion
What affects retained earnings? Retained earnings are affected by an increase or decrease in a company’s net income and the amount of cash dividends paid to shareholders. This means that any item such as the purchase or sale of assets, taxes, cost of inventory, and all other sources of income or expenditure which have a direct impact on the net income also have an impact on the company’s retained earnings.
The retained earnings of a company are also one of the metrics used in determining a company’s profitability and its overall financial health.
Blessing Peter Titus
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Blessing's experience lies in business, finance, literature, and marketing. She enjoys writing or editing in these fields, reflecting her experiences and expertise in all the content that she writes.
