What Determines Retained Earnings?
"Retained earnings" is an accounting term that is of abiding interest to stock investors because it identifies accumulated net income of a company that is not distributed to that company's stockholders as dividends. The corporation retains these net earnings, with the cumulative balance reported in the stockholder's equity area of the company's balance sheet, and on the statement of retained earnings. The total value of stockholder equity is calculated by subtracting the corporation's liabilities from its total assets. Retained earnings contributes to stockholders' ownership of the organization's net assets.
Retained earnings is a cumulative number, representing all net profits, since the corporation's inception, that have not been paid to stockholders as dividends. Should the corporation experience any net losses over the years, these will be subtracted from the cumulative retained earnings balance in the accounting records. For example, a corporation that's been in existence for 12 years may have had net profits for 11 years, totaling $230,000, and a $20,000 loss in one year. It would report retained earnings of $210,000 on its balance sheet.
All stockholders, also called shareholders, collectively own -- or have equity in -- a corporation's net assets. Strong stockholders' equity is critical for investor decisions, indicating corporate stability and profitability. Along with the original capital provided by the first purchasers of company stock, shareholders' equity is increased by the cumulative retained earnings of the organization. Each year the company's net profit minus any dividends paid equal its retained earnings for the calendar or fiscal year, which is then added to prior years' retained earnings.
Stockholders are not guaranteed of receiving dividends each year. A corporation's board of directors examines the organization's net profit after taxes each year to decide whether or not to offer dividends. Deciding factors usually include the amount of net profit, the age or stability of the company, and the need to keep funds for reinvestment. Many boards adopt a formal dividend policy to help guide their decisions to pay or not to pay dividends.
Determining and calculating retained earnings is not overly difficult, but the composition of retained earnings holds great significance to an investor. A corporation may have an impressive amount of retained earnings, but investors examine the company's length of time in business and the frequency and size of dividend payments. For example, a company consistently, but modestly, profitable may build up large retained earnings if it seldom pays dividends to stockholders. Corporations with this profile will find their stock price negatively affected because they are not as attractive to investors as other companies that have large retained earnings and consistent dividend payments.
Statement of Retained Earnings
A component of a corporation's financial reports is the statement of retained earnings. This statement is important to investors as it clearly reports all of the corporation's retained earnings changes for the current period. This report is typically prepared at the end of each quarter and at the end of the calendar or fiscal year. Investors can quickly learn about the current net earnings and dividend distribution, if any, along with the accumulated retained earnings of the corporation.