Retained earnings: Definition, importance, and calculation

What are retained earnings?

Retained earnings (RE) are the cumulative net earnings or profits of a company after accounting for dividend payments. It is the portion of profit that management "retains" for internal use rather than paying out to its owners. Think of it as a company's long-term savings account, which is built up over time by its own profitable operations ².

This figure is recorded in the shareholders' equity section of a company's balance sheet, as stipulated by IFRS ¹¹.

A common misconception is that retained earnings represent a surplus of cash sitting in a bank account. This is incorrect. Retained earnings are an accounting concept, not a direct measure of cash. The profits that are retained have likely already been used to fund various aspects of the business, such as ^3.8:

• Purchasing new machinery or equipment (assets)
  
• Paying down debt (liabilities)
  
• Funding research and development (R&D)
  
• Expanding operations into new markets
  

Essentially, retained earnings show the total amount of profit that has been successfully reinvested into the company since its inception. This makes it a crucial indicator of a company's ability to generate value from its own capital, a process often referred to as "organic growth" ⁵.

What is the importance of retained earnings?

Retained earnings are a cornerstone of corporate finance, and their importance can't be overstated. A healthy and growing retained earnings balance provides numerous strategic advantages and signals financial strength to the market ⁵.

1. Primary source of internal financing

Retained earnings are the most accessible and cheapest source of capital for a company. By using its own profits to fund growth, a company can avoid the costs and obligations associated with taking on debt (interest payments) or issuing new equity (diluting ownership) ¹.

2. Fueling business growth and expansion

The capital represented by retained earnings is the engine of growth. It can be used to invest in new projects, launch new product lines, upgrade technology, hire more employees, or acquire other companies—all without seeking external financing ⁵.

3. Providing a financial cushion

A substantial retained earnings balance acts as a financial buffer. It helps a company weather economic downturns, unexpected market shifts, or industry-specific challenges. During lean times, these accumulated profits can cover operational costs and prevent the company from having to take on high-interest debt out of desperation ⁹.

4. Enhancing creditworthiness

Lenders and creditors view a strong history of retained earnings favourably. It demonstrates that the company is consistently profitable and has a disciplined approach to capital management. This can lead to better loan terms, lower interest rates, and easier access to credit when needed ¹³.

5. Increasing investor confidence

For investors, a steady increase in retained earnings signals that the company isn't only profitable but is also effectively reinvesting those profits to create more value. This can lead to an increase in the company's stock price over the long term, a phenomenon known as capital appreciation ⁹.

Understanding key components of retained earnings

To accurately calculate and understand retained earnings, you must first grasp the 3 key components of its formula. These elements link the income statement to the balance sheet and show how a company's performance in one period affects its cumulative position.

Net income

Net income, often called the "bottom line," is the amount of profit a company has left over after subtracting all of its costs and expenses from its total revenue. These expenses include the cost of goods sold (COGS), operating expenses (like salaries, rent, and marketing), interest on debt, and taxes. Net income is calculated on the company's income statement for a specific accounting period (e.g., a quarter or a year). It's the single most important driver of retained earnings; a positive net income increases the retained earnings balance, while a net loss decreases it ¹.

Dividends paid

Dividends are payments made by a corporation to its shareholders, usually as a distribution of profits. The decision to pay dividends is made by the company's board of directors. When a company chooses to pay dividends, it's essentially deciding to return a portion of its profits directly to its owners rather than reinvesting them. Dividends can be paid in cash or in the form of additional stock. For the purpose of the retained earnings calculation, cash dividends are the most direct and common reduction from the retained earnings account ^4,7.

Beginning retained earnings

The retained earnings account is cumulative, meaning it carries over from one accounting period to the next. The beginning retained earnings balance is simply the ending retained earnings balance from the previous period. For a brand new company, this figure would be zero. For an established company, it represents the sum of all profits retained since its inception up to the start of the current period. This figure serves as the starting point for the current period's calculation ⁶.

How to calculate retained earnings

The calculation for retained earnings is straightforward and provides a clear link between a company's profitability and its balance sheet. The retained earnings formula is 6,8:

• Ending Retained Earnings = Beginning Retained Earnings + Net Income (or Net Loss) − Cash Dividends Paid
  

Let's walk through a practical example:

Imagine Company ABC is preparing its financial statements for the year ending December 31, 2025.

1. Find the Beginning Retained Earnings: From its balance sheet on December 31, 2024, Company ABC had an ending retained earnings balance of HK$500,000. This becomes the beginning balance for 2025.
   
2. Determine the Net Income: From its income statement for the 2025 fiscal year, Company ABC reports a net income of HK$120,000.
   
3. Identify Dividends Paid: During 2025, the company's board of directors declared and paid cash dividends to its shareholders totalling HK$30,000.
   

Now, we can plug these numbers into the formula:

• Ending Retained Earnings = HK$500,000 + HK$120,000 − HK$30,000
  
• Ending Retained Earnings= HK$590,000
  

So, the retained earnings balance that will appear on Company ABC's balance sheet for December 31, 2025, is HK$590,000. This new figure will then serve as the beginning retained earnings for the 2026 fiscal year.

How to interpret retained earnings

The final retained earnings number is more than just a figure on a balance sheet; it tells a story about the company's financial health, maturity, and strategic priorities.

High retained earnings

A high or consistently growing retained earnings balance is generally a positive sign. It indicates:

• Consistent profitability: The company has a history of generating profits.
  
• Financial strength: It has a solid financial foundation and can fund its own growth.
  
• Growth-Oriented Strategy: This is particularly common in younger, high-growth companies (like those in the technology or biotech sectors). These companies often reinvest nearly all of their profits to scale operations, fund R&D, and capture market share. They prioritize long-term capital appreciation over short-term dividend payouts.
  

However, an excessively high retained earnings balance can sometimes be a red flag. It might suggest that the company's management isn't deploying its capital efficiently. If the company is hoarding cash and not finding productive investment opportunities, shareholders may argue that the money would be better off returned to them as dividends so they can invest it elsewhere for a better return ¹.

This tension between retaining earnings and paying dividends is often referred to as the dividend puzzle. While some investors prefer dividends as a tangible reward, others favour reinvestment for future growth. The “puzzle” lies in the fact that despite decades of research, there's still no clear consensus on why companies pay dividends when, in theory, reinvestment should create more value in the long run.

Negative retained earnings

When a company's retained earnings balance is negative, it's referred to as an accumulated deficit. This occurs when a company's cumulative net losses and dividend payments exceed its cumulative net profits. An accumulated deficit can signal several things ¹:

• Early Stage of Business: Many startups and new companies operate at a loss for their first few years as they invest heavily in development and market penetration. A deficit in this context is often expected.
  
• Severe Financial Distress: For an established company, a move into a deficit position is a serious warning sign. It indicates a prolonged period of unprofitability that has eroded its equity base.
  
• Poor Management: It could be a result of poor strategic decisions, inefficient operations, or a failure to adapt to changing market conditions.
  

An accumulated deficit makes it difficult to attract investors and secure loans, as it raises serious questions about the company's long-term viability.

The impact of retained earnings on business growth

The management of retained earnings has a profound and direct impact on both the company's trajectory and the returns its shareholders can expect 5.

The impact of retained earnings on business growth

As previously mentioned, retained earnings are the lifeblood of organic business growth. The decision to retain earnings is a strategic choice to invest in the company's future. This internal funding can be directed towards a variety of growth initiatives, such as:

• Research & Development (R&D): Developing new products or improving existing ones to stay ahead of the competition.
  
• Capital Expenditures (CapEx): Purchasing new assets like buildings, machinery, and technology to increase capacity and efficiency.
  
• Market Expansion: Funding the costs associated with entering new geographic regions or demographic segments.
  
• Mergers & Acquisitions (M&A): Using the accumulated capital as a down payment or full payment to acquire another company, thereby gaining market share, technology, or talent.
  
• Debt Repayment: Paying down existing liabilities to strengthen the balance sheet and reduce interest expenses, which in turn boosts future net income.
  

Without a healthy flow of retained earnings, a company would be forced to rely on more expensive and restrictive external financing to pursue these opportunities.

Amazon, for example, is known for building up retained earnings over the years and reinvesting them in logistics, data centres, and new ventures, which helped it become a trillion-dollar company.

Apple, on the other hand, has also accumulated significant retained earnings, but much of it has been channelled into share buybacks and dividends, rewarding shareholders while still funding innovation.

The impact of retained earnings on shareholders

For shareholders, the company's retained earnings policy creates a fundamental trade-off between immediate returns and potential long-term gains.

• Dividend Payouts: When a company chooses to pay a large portion of its net income as dividends, shareholders receive an immediate cash return on their investment. This is often preferred by income-oriented investors who rely on dividends for a steady cash flow.
  
• Capital Gains: When a company retains a large portion of its net income, it is betting that it can reinvest that money at a higher rate of return than the shareholder could achieve on their own. If successful, this reinvestment leads to business growth, higher future profits, and ultimately, an increase in the company's stock price. The shareholder's return comes in the form of capital appreciation.
  

The ideal strategy depends on the company's industry, maturity, and growth opportunities. A mature, stable company in a low-growth industry (like a utility) is expected to pay out a significant portion of its earnings as dividends. A young tech company with vast growth potential is expected to retain most, if not all, of its earnings to fuel that expansion.

Cut costs and keep more of your revenue with Aspire

Ultimately, the goal of any business is to maximise its net income, as this is the source of the retained earnings that fuel growth and create shareholder value. One of the most effective ways to increase net income is to gain tight control over business expenses and streamline financial operations. This is where a modern financial OS like Aspire can make a significant impact.

Effective management of retained earnings begins long before the final calculation. It starts with the day-to-day decisions that affect your company's profitability. By optimising how you manage your spending, payments, and receivables, you directly increase the amount of profit available for retention and reinvestment.

This is where Aspire’s Expense Management can help. It streamlines your overall expense management so you gain a clear, real-time view of your actual business expenses. With Aspire’s Expense Management, you can:

• Set spending limits at the client, budget, or team level and monitor these expenses in real time, ensuring they stay aligned with the budget.
  
• Review, approve, and disburse claims from one dashboard. Employees can submit claims within seconds by scanning receipts via the Aspire mobile app, ensuring that no receipt is missed.
  
• Democratise the purchasing process by issuing unlimited corporate cards to team members. You can set spend limits and assign each card to a specific merchant or project, helping you avoid unauthorised transactions or overspending.
  

By leveraging a solution like Aspire to control costs and enhance operational efficiency, you can directly boost your net income. A higher net income means more capital can be added to your retained earnings each period, accelerating your ability to invest in growth, strengthen your financial position, and build long-term value for your company.