Why retained earnings increase

Older companies may be able to pay a small dividend and still see a retained earnings increase if net income is high enough. Plus, older companies tend to have less need to make major investments in growth than newer, younger companies in the same industry.

Neil Kokemuller has been an active business, finance and education writer and content media website developer since He has been a college marketing professor since Kokemuller has additional professional experience in marketing, retail and small business.

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More Articles 1. Profits give a lot of room to the business owner s or the company management to use the surplus money earned. This profit is often paid out to shareholders, but it can also be reinvested back into the company for growth purposes. The money not paid to shareholders counts as retained earnings. The decision to retain the earnings or to distribute them among shareholders is usually left to the company management. However, it can be challenged by the shareholders through a majority vote because they are the real owners of the company.

Management and shareholders may want the company to retain the earnings for several different reasons. In the long run, such initiatives may lead to better returns for the company shareholders instead of those gained from dividend payouts. Paying off high-interest debt may also be preferred by both management and shareholders, instead of dividend payments. On the other hand, when a company generates surplus income, a portion of the long-term shareholders may expect some regular income in the form of dividends as a reward for putting their money in the company.

Traders who look for short-term gains may also prefer dividend payments that offer instant gains. Most often, the company's management takes a balanced approach.

It involves paying out a nominal amount of dividends and retaining a good portion of the earnings, which offers a win-win. Dividends can be distributed in the form of cash or stock. Both forms of distribution reduce retained earnings. Cash payment of dividends leads to cash outflow and is recorded in the books and accounts as net reductions.

On the other hand, though stock dividends do not lead to a cash outflow, the stock payment transfers part of the retained earnings to common stock. For instance, if a company pays one share as a dividend for each share held by the investors, the price per share will reduce to half because the number of shares will essentially double. Because the company has not created any real value simply by announcing a stock dividend, the per-share market price is adjusted according to the proportion of the stock dividend.

A growth-focused company may not pay dividends at all or pay very small amounts because it may prefer to use the retained earnings to finance activities such as research and development, marketing, working capital requirements, capital expenditures, and acquisitions to achieve additional growth. Such companies have high retained earnings over the years.

A maturing company may not have many options or high-return projects for which to use the surplus cash, and it may prefer handing out dividends. Such companies tend to have low RE. Both revenue and retained earnings are important in evaluating a company's financial health, but they highlight different aspects of the financial picture.

Revenue sits at the top of the income statement and is often referred to as the top-line number when describing a company's financial performance. Revenue is the money generated by a company during a period but before operating expenses and overhead costs are deducted. In some industries, revenue is called gross sales because the gross figure is calculated before any deductions. Retained earnings are the portion of a company's cumulative profit that is held or retained and saved for future use.

Retained earnings could be used for funding an expansion or paying dividends to shareholders at a later date. Retained earnings are related to net as opposed to gross income because it's the net income amount saved by a company over time.

For an analyst, the absolute figure of retained earnings during a particular quarter or year may not provide any meaningful insight. Observing it over a period of time for example, over five years only indicates the trend of how much money a company is adding to retained earnings. As an investor, one would like to know much more—such as the returns the retained earnings have generated and if they were better than any alternative investments. Additionally, investors may prefer to see larger dividends rather than significant annual increases to retained earnings.

One way to assess how successful a company was in using the retained money is to look at a key factor called retained earnings to market value. It is calculated over a period of time usually a couple of years and assesses the change in stock price against the net earnings retained by the company. For example, during the period between September and September , Apple Inc. As Morningstar indicates, Apple had the following EPS and dividend figures over the given time frame, and summing them up gives the above values for total EPS and total dividend.

If the company had not retained this money and instead taken an interest-bearing loan, the value generated would have been less due to the outgoing interest payment.

RE offers free capital to finance projects, allowing for efficient value creation by profitable companies. However, readers should note that the above calculation is indicative of the value created with respect to the use of retained earnings only, and it does not indicate the overall value created by the company.

Companies publicly record retained earnings under the shareholders' equity section on the balance sheet. For instance, Apple Inc. As the formula suggests, retained earnings are dependent on the corresponding figure of the previous term.