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Retained Earnings

Guide to Understanding Retained Earnings

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Retained Earnings

In This Article
  • What is the formula for calculating retained earnings?
  • Which factors should be considered when evaluating a company’s retained earnings balance?
  • What specific drivers cause the retained earnings balance to increase (or decrease)?
  • Is it possible for retained earnings to turn negative?

Retained Earnings Formula

The retained earnings of a company refer to the profits generated, and not issued out in the form of dividends, since inception.

On the balance sheet, the relevant line item is recorded within the shareholders’ equity section.

The formula is equal to the prior period balance plus net income – and from that figure, the issuance of dividends to equity shareholders is subtracted.

Formula
  • Retained Earnings = Prior Period Balance + Net Income – Dividends

In effect, the equation calculates the cumulative earnings of the company post-adjustments for the distribution of any dividends to shareholders.

The prior period balance can be found on the beginning of period balance sheet, whereas the net income is linked from the current period income statement.

Value Drivers of Earnings Retention

Higher retained earnings mean increased net earnings and fewer distributions to shareholders (and vice versa).

One influential factor is the maturity of the company, as a low-growth company with minimal opportunities for capital allocation is more likely to issue dividends to shareholders.

In other words, cash from operations is sufficient to fund reinvestment needs.

However, opportunities to place capital for expansion are limited (or the risk profile does not meet the return hurdle).

With that said, a high-growth company with minimal free cash flow will conversely re-invest toward extending its growth trajectory (e.g. research & development, capital expenditures).

And it’s also likely the company probably could not afford to issue dividends to shareholders in the first place, even if it wanted to compensate shareholders.

Next, another important consideration is the dividend policy of the company.

Given the formula stated earlier, the relationship between the two should be rather intuitive – i.e. a company that issues dividends routinely is going to have lower retention, all else being equal.

Even if a company underperforms, the management teams of publicly traded companies tend to be very reluctant to cut dividends out of fear of sending out a negative message to the markets that could cause a significant drop in the current share price.

Furthermore, the cyclicality of the industry can also be a contributing factor, i.e. when a company operates in an industry that is very cyclical, the management team reserves more earnings as a risk-averse measure in case of an impending downturn.

Negative Retained Earnings Balance

If a company has consistently incurred substantial losses at the “bottom line,” its retained earnings balance could eventually become negative, which is recorded as an “accumulated deficit” on the books.

But while the first scenario is a cause for concern, a negative balance could also result from an aggressive dividend payout – e.g. dividend recapitalization in LBOs.

Caveat to Positive Growth

As a broad generalization, if the retained earnings balance is gradually accumulating in size, this demonstrates a track record of profitability (and a more optimistic outlook).

However, from a more cynical view, the growth in retained earnings could be interpreted as management struggling to find profitable investments and project opportunities worth pursuing.

Retained Earnings Calculator – Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Retained Earnings Calculation Example

For our retained earnings modeling exercise, the following assumptions will be used for our hypothetical company as of the last twelve months (LTM), or Year 0.

Model Assumptions (Year 0)

  • Retained Earnings – Beginning of Period: $200m
  • Net Income: $50m
  • Common Dividends: $10m

Upon combining the three line items, we arrive at the end of period balance – for instance, Year 0’s ending balance is $240m.

  • Year 0 = $200m + $50m – $10m

Note how in our roll-forward schedule, net income has a positive impact on the end of period balance (i.e. cash inflow) while common dividends have a negative effect (i.e. cash outflow)

Projection of Retained Earnings

In the next step, we’ll forecast the metric for the next five years, with two operating cases to pick from:

  1. Upside Case: Consistent operating performance with profit margins in-line with historical trends – therefore, the common dividend issuance program remains in place.
  2. Downside Case: Poor operating performance with declining profitability – management is forced to cut the dividend (and eventually put a complete end to the payouts in later periods)

Upside Case – Forecast Assumptions

  • Net Income: Straight-Line (i.e. Held Constant)
  • Common Dividends: Straight-Line

Downside Case – Forecast Assumptions

  • Net Income: Reduction by $25m Per Year
  • Common Dividends: Payout Value Decline of $2m Per Year

In the “Upside Case”, the ending balance increases from $240m in Year 0 to $440m by Year 5 – reflecting how management’s decision to retain a greater proportion of its net income has a net positive impact on the retained earnings balance.

As for the “Downside Case”, the ending balance declined from $240m in Year 0 to  $95m by the end of Year 5 – even with the company attempting to offset the steep losses by gradually cutting off the dividend payments.

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