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What are Retained Earnings?

By Bajaj Broking Team

March 17, 2025

7 mins read

Share Market

Synopsis:

Retained earnings stand for the cumulative net profit of a business that has not been distributed to shareholders as dividends over the years. When a business wants to reinvest or pay an obligation, Read more..it tends to retain a larger portion of its earnings. On the other hand, if it does not need to reinvest or pay an obligation, it tends to retain a lesser portion of its earnings. You can find a firm’s retained earnings under the equity section of its balance sheet or on its statement of changes in equity. Read less

Retained earnings represent the cumulative net profit of a business after paying dividends to its shareholders. Here, the word “retained” is very important, as it conveys that businesses tend not to distribute their entire profits as dividends to shareholders. Instead, they retain a portion of their profits (sometimes they retain the entire profit) and keep it with themselves. Typically, a firm uses its retained earnings to invest in its business so that it can grow. Retained earnings are also used to deal with losses in future years. Having learnt what retained earnings are, let us dig deeper into this topic.

Importance of Retained Earnings in Business Growth

A company’s retained earnings are extremely important for its growth. Typically, a firm retains a large portion of its earnings if it expects to grow at a significant rate. To understand why, let us say a firm estimates that it will grow at a high rate over the next five years. Still, it distributes its entire profit as dividends to its shareholders.

Hence, it is left with no earnings to reinvest in its business. What can it do? It can raise finance through debt; however, that will require it to pay interest. It can raise money through equity, but that will dilute the stake of existing shareholders. Hence, reinvesting retained earnings is considered one of the reasonable ways to grow a business.

At the same time, when a business does not expect to grow considerably, it can distribute a large portion of its earnings as dividends to shareholders.

How to Calculate Retained Earnings

You will get a better understanding of retained earnings if you learn how to calculate it. So, let us take an example to throw light on this concept.

Suppose a company had retained earnings amounting to ₹ 1 crore at the beginning of the current financial year. During the year, it earns a net profit of ₹ 25 lakh and it decides to distribute ₹ 10 lakh as dividends to its shareholders. So, its retained earnings at the end of the year can be calculated using the following formula:

Retained earnings at the end of a year = Retained earnings at the beginning of a year + Net profit/loss earned during a year – Dividends distributed to shareholders

Retained earnings at the end of a year = ₹ 1 crore + ₹ 25 lakh – ₹ 10 lakh = ₹ 1.15 crore

Factors Affecting Retained Earnings

Retained earnings can provide you with interesting insights about a company’s performance. Hence, you need to understand the factors that impact them:

Performance of a business: The most important factor that affects retained earnings is a business’s performance. If a company performs well, it means it can sell its products/services well and earn a decent profit, which should increase its retained earnings. Conversely, a firm that is struggling to perform well will find it difficult to grow its retained earnings.
Scope for expansion: If a business thinks that it has a lot of scope to grow and expand, it can retain a significant portion of its earnings. Or, it may even retain its entire earnings without distributing any dividend. However, if there is not much scope for expansion, it can distribute most of its earnings as dividends.
Economic scenario: No matter how good a business is, it will find it tough to remain completely insulated from the economic scenario. Hence, if the economic scenario is tough, a company’s net profit and retained earnings may get affected. Conversely, when the economic scenario is conducive, a firm’s retained earnings may grow.

Retained Earnings vs. Dividends

If you want to analyse a company’s financials, you need to understand the difference between retained earnings and dividends. So, please refer to the following table:

Criteria	Retained Earnings	Dividends
Meaning	The portion of its earnings that a company does not distribute as dividends to shareholders is known as retained earnings.	The portion of a company’s earnings that is distributed to shareholders as a reward for their investment in the company is called dividends.
Where are they shown?	Retained earnings are shown on a firm’s balance sheet under the equity section. They are also shown on a firm’s statement of changes in equity.	Dividends are shown on a company’s profit & loss account and balance sheet.
What do they show about a company’s performance?	If a company retains a large part of its retained earnings, it is possible that it will either invest significantly in its business or it has to pay an obligation.	If a company increases its dividend payout considerably, it means that it wants to reward its shareholders and it does not have significant investment requirements.

Common Misconceptions About Retained Earnings

The most common misconceptions about retained earnings are explained below:

Retained earnings reflect a pool of cash: This is the most common misconception about retained earnings. The fact is that retained earnings is an accounting concept. They are a part of a company’s profit that is not distributed as dividends. In other words, if a company has a certain amount recorded as its retained earnings, it is not necessary that it has that much cash parked in its bank account.
Retained earnings show that a company is making a lot of profit: This is another common misconception. If a company is able to retain some of its profit, it does not mean that it is making a lot of profit. It only means that it decides not to distribute the entire profit as dividends to shareholders. The fact is that retained earnings accumulate over a period of time. Hence, if a company shows a significant amount under its retained earnings, some people mistakenly believe that it is making a lot of profit.
Retained earnings reflect a firm’s financial stability: While retained earnings can serve as an indicator of a company’s financial stability, they alone are not sufficient to judge whether a firm is stable or not. It is like judging the health of a person by merely looking at his body mass index. To ascertain whether a company is stable, we need to consider many other factors apart from its retained earnings.

How Retained Earnings Impact Shareholder Value

If retained earnings are reinvested wisely into a business, they can increase the profits and cashflows, which in turn can enhance shareholder value. Besides, when a company reinvests its retained earnings, it can propel its future profits, which can increase its share price, thereby improving shareholder value.

That said, for retained earnings to positively impact shareholder value, it is important that a business reinvests them well. Let us say that a company reinvests a large portion of its retained earnings in a plant; however, the plant ends up making losses. In this case, retained earnings can negatively impact shareholder value.

So, when you see a significant amount under retained earnings on a company’s balance sheet, you should check how it plans to reinvest the amount because that will tell you about the kind of impact its retained earnings can have on its shareholder value.

Retained Earnings in Financial Statements

Retained earnings appear on two financial statements of a company – the balance sheet and the statement of changes in equity.

On a firm’s balance sheet, you can find retained earnings under the equity section on the liabilities side. However, it will show you the amount accumulated under retained earnings over the years.

A firm’s statement of changes in equity shows you how its retained earnings change over a time period. This statement provides you with details about a company’s net profit, dividend, and any adjustments made to its retained earnings.

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