The Income Statement: Retained Earnings

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The Income Statement: Retained Earnings

Retained earnings is the amount of money that a company keeps for future use or investment (see example below).

Another way to look at it is as the earnings left over after dividends are paid out. Generally, a company has a set policy regarding the amount of dividends it will pay out every year: say, 30 percent of net earnings. In this case, 70 percent of net earnings become retained earnings.

The formula for retained earnings

Here is the formula:

Retained Earnings = Net Earnings – Dividends

Dividends and retained earnings are important to investors

To better understand retained earnings, we need to explain the nature of dividends. Dividends are cash payments made to the owners or stockholders of the company. A profitable year allows them to make such payments, although there generally are no obligations to make dividend payments.

When a company has both common and preferred stockholders, the company has two different types of dividends to pay. Every company has common stockholders. Dividend payments to common stockholders are optional and up to each company to decide whether or how it will make such payments. A firm may decide to plow all of its earnings into new investments to promote future growth. Preferred stockholders are in line before common stockholder if a dividend is declared. However, not all companies have preferred stockholders.

As an investor, to know what a company does with its net earnings is important. An investor needs to know the company’s dividend and retained earnings policies to decide whether the company’s objectives are in line with the investor’s. If the company pays dividends, it is income-oriented. If it retains earnings for future expansion, it is growth-oriented.