Understanding Retained Earnings

If you have read a company’s balance sheet before, you might have come across the term “retained earnings”. It refers to the amount of net income remaining after the business distributes dividends to the shareholders. To calculate the retained earnings correctly, business owners need to ensure that they have recorded all business transactions accurately for them to account for the profit generated for that period. If they think that this task is too time-consuming and they are not familiar with the accounting processes, they may consider hiring a bookkeeping firm in Singapore.

As a company runs its business operations, the earnings that it has generated can be either positive or negative. A positive figure indicates that the company has earned a profit, while a negative earning means that the business has suffered from a loss. In the case where the company has earned a positive profit, the company’s management or the business owners may use the money earned rather freely. Most of the time, companies would distribute the profits to the shareholders. However, it may also choose to re-invest the money back into the business so that it can develop and grow. The sum of money that the company did not pay to the shareholders is called retained earnings (Also see How to Classify Retained Earnings?).

Companies may use retained earnings in many different ways. Apart from the distribution of dividends, companies may choose to invest the retained earnings for expansion purposes. They can use that sum of money to launch a new product, increase its production capacity and hire more employees. They may also use the money for merger and acquisition, which can result in better business prospects. Besides, some may choose to repurchase their own shares or to pay the outstanding loans that they have not settled by using the retained earnings.

Typically, the company’s management will be the one that decides whether it wants to distribute the profits to the shareholders as dividends or it prefers retaining the earnings for the business. Nevertheless, the shareholders may challenge the management’s decision via majority vote as they are actually the owner of the company. The management and the shareholders may have a different point of view on how the company should utilise the retained earnings. If this happens, the company’s management will take a balanced approach, that is, to distribute a nominal amount of dividend to the shareholders while keeping sufficient retained earnings for the business (Also see Essential Lessons That You Might Not Have Learnt from Business Schools).

When it comes to assessing the financial health of a company (Also see Consequences of Poor Bookkeeping in your Company), some would say that retained earnings would be a reliable piece of information, while others may think that revenue is more important. In fact, both are crucial, yet the aspects that they emphasise are different. Retained earnings are part of the company’s profit that is kept to be used in the future. On the other hand, revenue refers to the total income (Also see An Overview of Income Summary Account) that the company has earned before any deduction of costs or expenses. It is also called the “top line” as the figure of revenue appears on the first line of the company’s income statement.