Retained earnings are the profits that a company has earned to date, less any dividends or other distributions paid to investors. This amount is adjusted whenever there is an entry to the accounting records that impacts a revenue or expense account. A large retained earnings balance implies a financially healthy organization. The formula for ending retained earnings is:
Beginning retained earnings + Profits/losses - Dividends = Ending retained earnings
A company that has experienced more losses than gains to date, or which has distributed more dividends than it had in the retained earnings balance, will have a negative balance in the retained earnings account. If so, this negative balance is called an accumulated deficit.
A growing company normally avoids dividend payments, so that it can use its retained earnings to fund additional growth of the business in such areas as working capital, capital expenditures, acquisitions, research and development, and marketing. It may also elect to use retained earnings to pay off debt, rather than to pay dividends. Another possibility is that retained earnings may be held in reserve in expectation of future losses, such as from the sale of a subsidiary or the expected outcome of a lawsuit.
As a company reaches maturity and its growth slows, it has less need for its retained earnings, and so is more inclined to distribute some portion of it to investors in the form of dividends. The same situation may arise if a company implements strong working capital policies to reduce its cash requirements.
When evaluating the amount of retained earnings that a company has on its balance sheet, consider the following points:
Age of the company. An older company will have had more time in which to compile more retained earnings.
Dividend policy. A company that routinely issues dividends will have fewer retained earnings.
Profitability. A high profit percentage eventually yields a large amount of retained earnings, subject to the two preceding points.
Cyclical industry. When a business is in an industry that is highly cyclical, management may need to build up large retained earnings reserves during the profitable part of the cycle in order to protect it during downturns.