Retained Earnings

Retained earnings are the total of a corporation's net income from all past periods, less any net losses and less all dividends declared to shareholders. They represent profits that have been kept, or retained, in the business rather than paid out. Retained earnings form one of the main components of stockholders' equity on the balance sheet, alongside contributed capital such as common stock and paid-in capital.

A common misunderstanding is that retained earnings are a pile of cash. They are not. They are a claim within equity that tells readers how much of the company's net assets came from profits rather than from shareholders' investment. The cash generated by those profits may have been spent on inventory, equipment, acquisitions or debt repayment. A company can have large retained earnings and little cash, or the opposite.

The balance at the end of a period is:

• $\text{Beginning RE}$ is the retained earnings balance at the start of the period.
• $\text{Net income}$ is profit for the period from the income statement; a net loss is subtracted instead.
• $\text{Dividends}$ are cash, stock and property dividends declared during the period, whether or not yet paid.

Certain other items also go straight to retained earnings, such as a prior period adjustment to correct an error in earlier statements and the cumulative effect of some changes in accounting principle.

A company begins the year with retained earnings of $1,200,000. It earns net income of $450,000 and declares cash dividends of $150,000. Ending retained earnings are $1,200,000 plus $450,000 minus $150,000, or $1,500,000.

During the year, revenues and expenses are recorded in temporary accounts. At year end, closing entries transfer their net balance through the income summary account to retained earnings: the $450,000 profit is debited to income summary and credited to retained earnings. When the dividends are declared, the company debits retained earnings, or a dividends declared account that is later closed to retained earnings, and credits dividends payable. Because it carries over from year to year, retained earnings is one of the permanent accounts.

When cumulative losses and dividends exceed cumulative profits, the balance becomes negative and is usually reported as an accumulated deficit. This is common in start-ups and in companies recovering from large losses. Many state laws limit dividends when equity is impaired, so a deficit can restrict a company's ability to pay shareholders.

A board may also set aside part of retained earnings for a stated purpose, such as plant expansion or as required by a loan agreement. This creates appropriated retained earnings, which signals that the amount is not available for dividends. Appropriation does not move any cash; it simply reclassifies part of the balance within equity.

Analysts look at the trend in retained earnings to see whether a company is growing its equity from profits. The share of profit retained is the retention ratio, which is 1 minus the dividend payout ratio. In the example, the company retained $300,000 of $450,000, a retention ratio of about 67 percent. Mature companies with few investment opportunities often pay out more, while growth companies tend to retain most of their earnings. Changes in the balance are presented in a statement of retained earnings or as a column in the statement of stockholders' equity. Retained earnings also feature in some credit models, such as the Altman Z-score, because a long record of retained profits is a sign of financial strength.