What is Retained Earnings?
Retained earnings is the accumulation of profits of the company. This is the part of total profits which is not distributed as the dividends to the shareholders of the company. Retained earnings commonly using for working capital and to purchase non-current assets of the company or using to pay off the debts of the company. Actually, this is not the method of raising finance, but is the accumulation of profits over the years of the company.
Retained earnings are presented on the balance sheet of the company under the shareholders equity section at the end of accounting period. Retained earnings are called in different names, such as : self finance, inter finance and plugging back of profits. Retained earnings is the part of total profits.
Formula of Retained Earnings
The formula of retained earnings are as follows:
| Opening Retained Earnings | ***** |
| Add: Net Profit/ (Loss) during the period | *** |
| Less : Cash Dividends | (***) |
| Less : Stock Dividends | (***) |
| Retained Earnings During this Period (will be shown on the Balance Sheet ) | **** |
Advantages of retained earnings
Retained earnings is very common and hassle free mode of finance. The company need not pay fixed installment time to time and has not dividends & interest issues. However, the advantages of retained earnings are as follows:
- Easy finance for expansion and diversification: A company prefers retained earnings as a source of finance for expansion and diversification for its easy injection. It has not fixed installment payment issues and it is interest and dividend free source of finance.
- Cheap sources of finance: Retained earnings is the very least cost sources of finance because it has not flotation costs like raising finance from the financial institution.
- No Fixed Obligation: If the company wants to inject equity finance it has to pay dividends to its shareholders and if the company wants to raising funds from the financial institution it has to pay interest. If the company fails to pay dividends, it may reduce the share price of the company and if the fails to pay installment (with interest) it may declare as insolvent.
- Flexible Sources of Finance: When a company has sufficient retained earnings , it may take any investment opportunities without delay because it has not processing time and other complexities.
- Increase the Share value of the company: Since the company is not obliged to pay dividends or interest against the finance from retained earnings, it will reduce the Weighted Average Cost of Capital (WACC) of the company and increase the share value of the company.
- Increase Earnings Capacity : As it has no interest payment issues, it will enhance earnings capacity of the of the company.
Disadvantages of the Retained Earnings
Retained also have some disadvantages that are enumerated as follows:
- Misuses the fund: The management of the company may manipulate the value of the share of the company in the stock market and can misuse the retained earnings.
- Leads to Monopolies: Excessive use of retained earnings may create a monopolistic attitude to the company.
- Over Capitalization: If any company frequently using retained earnings, it may lead to insufficient source of finance.
- Tax Benefit foregone: If the company using retained earnings as a source of finance, the company can not exercise tax benefits against interest expenses that may lead to pay excessive tax.
- Dissatisfaction of Management: Management of the company could be dissatisfied if the company uses retained earnings as a source of finance because continuous uses of retained earnings as a source of finance may deprive shareholders from getting expected dividends.
Presentation of Retained Earnings
ABC LTD.
Balance Sheet as on 31st December’2017
| ASSETS: | |
| Cash | 563,672 |
| Accounts Receivable | 55,000 |
| Inventory | 78,579 |
| Property & Equipment | 479,525 |
| Total Assets | 11,76,776 |
| LIABILITIES: | |
| Accounts Payable | 39,525 |
| Debt | 489,668 |
| Total Liabilities | 529,193 |
| SHAREHOLDER’S EQUITY: | |
| Equity Capital | 579,000 |
| Retained Earnings | 68,583 |
| Total Shareholder’s Equity | 647,583 |
| Total Liabilities & Shareholder’s Equity | 11,76,776 |
Journal Entries for Retained Earnings
| When the Net Profit transfer to Retained Earnings during the closing process | Income Statement ……………….. Debit Retained Earnings ………………..Credit |
| When the company incurs net loss | Retained Earnings …………………… Debit Income Statement ……………………Credit |
| When the Dividends are recognized | Retained Earnings ………………………. Debit Dividends Payable ……………………….Credit |
Conclusion
However, continuous uses of retained earnings may reduce the financial strength of the company. If a company uses its retained earnings, it may failed taking the investment opportunities to a new project. Another disadvantages of retained earnings is the company will not be entitled to get tax benefit from the uses fund which can possible against the interest of debt. Even though, financial analysts consider the retained earnings as the first choice of expanding the business.