Retained Earnings

Definition: The Retained Earnings represent that portion of the equity earnings (left after deducting the tax and preference dividends), which is sacrificed by the equity shareholders and is ploughed back into the firm to reinvest these in the core business operations, such as paying off the debt obligations or purchasing a capital asset.

In a balance sheet, you often come across the term reserves and surplus, which essentially represents the accumulated retained earnings, i.e. the total profits of the firm and is considered as the crucial source of long-term finance.

Advantages of Retained Earnings

These earnings are viewed favorably due to the following reasons:

  • These earnings are readily available, and the firm is not required to seek help from the shareholders or lenders in case of urgency of funds.
  • The use of retained earnings reduces the cost of issuing the external equity and also eliminates the losses incurred on under-pricing.
  • There will be no dilution of control and ownership, in case the firm relies on the retained earnings.
  • Generally, the stock market views the equity issue as doubtful and therefore, these earnings do not carry a negative connotation.

Disadvantages of Retained Earnings

Despite several advantages of the accrual earnings, it is not free from certain bottlenecks which are as follows:

  • The amount raised through the accrual earnings could be limited and also it tends to be highly variable because certain firms follow a stable dividend policy.
  • The opportunity cost of these earnings is relatively high because it shows that amount of earnings, which have been foregone by the equity shareholders.
  • Some companies do not give much importance to the opportunity cost of these earnings and invest these into sub-marginal projects that have negative NPV.

The retained earnings are also known by different names, such as accumulated income, accumulated profit, accumulated earnings, earned surplus, undistributed earnings, etc.

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