What are Retained Earnings?
Retained Earnings measures the total accumulated profits kept by the company to date since inception, which were not issued as dividends to shareholders.
The discretionary decision by management to not distribute payments to shareholders can signal the need for capital reinvestment(s) to sustain existing growth or to fund expansion plans on the horizon.
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How to Calculate Retained Earnings
The retained earnings of a company refer to the profits generated, and not issued out in the form of dividends, since inception.
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.
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.
Retained Earnings Formula
The formula for calculating retained earnings is as follows.
- Retained Earnings = Prior Period Balance + Net Income – Dividends
How to Interpret Retained Earnings
Value Drivers of Earnings Retention
Generally, a company with more retained earnings on its balance sheet is more profitable.
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).
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
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.
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.
Retained Earnings Calculation Example
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:
- Upside Case: Consistent operating performance with profit margins in-line with historical trends – therefore, the common dividend issuance program remains in place.
- 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.