Retained Earnings

What is Retained Earnings exactly?

‍Retained earnings represent the cumulative net profits that your company has earned since its inception, minus any dividends paid to shareholders. Think of it as the company's savings account—money that has been kept within the business rather than distributed to owners. This accumulated profit becomes part of the company's equity on the balance sheet, providing a source of funding for future growth, debt repayment, or cushion against future losses.

‍When your company generates profit, you face a fundamental choice: distribute it to shareholders as dividends or retain it within the business. Retained earnings represent the portion you've chosen to reinvest. This decision reflects your strategic priorities—whether to reward owners immediately or fuel expansion, research, or acquisitions. For many startups and growth companies, retained earnings provide vital capital without needing to seek external equity financing or take on additional debt.

‍Retained earnings are calculated by adding the current year's net profit (or subtracting net loss) to the opening retained earnings balance from the previous period. Dividends declared during the period are then deducted. This figure appears in the equity section of your balance sheet and flows through to your financial statements each accounting period, telling the story of your company's profitability and distribution decisions over time.

Why are Retained Earnings important for startups?

‍Retained earnings serve as a key indicator of your company's financial health and growth potential. For startups, building retained earnings demonstrates to investors that your business can generate profits and reinvest them wisely. It shows financial discipline and suggests that your company might become self-funding, reducing reliance on external capital. This can be particularly attractive during subsequent funding rounds, as it signals operational efficiency and sustainable growth.

‍Additionally, retained earnings provide a buffer against economic downturns or unexpected expenses. They represent funds you can access without diluting ownership through additional equity financing or taking on costly debt. This internal capital allows for strategic investments in research, hiring, or market expansion when opportunities arise, without the negotiation delays and costs associated with external fundraising.

How do Retained Earnings differ from revenue?

‍Revenue represents the total income generated from your business activities during a specific period, while retained earnings reflect the cumulative profits kept in the business over its entire lifetime. Revenue appears on your income statement and shows current sales performance, whereas retained earnings appear on your balance sheet and represent historical profitability after accounting for expenses, taxes, and dividends.

‍A company can have high revenue but negative retained earnings if it consistently operates at a loss or pays out substantial dividends. Conversely, a company with modest revenue but careful expense management might accumulate significant retained earnings over time. Understanding this distinction helps you make informed decisions about dividend policies versus reinvestment strategies.

Can Retained Earnings be negative?

‍Yes, retained earnings can be negative, indicating that your company has accumulated losses over time. This situation, often called an "accumulated deficit," occurs when cumulative losses exceed profits or when dividends exceed earnings. Negative retained earnings signal to investors and lenders that the business has struggled to generate sustainable profits, which may affect your ability to secure financing or attract new investment.

‍For startups, negative retained earnings are common in early years as you invest heavily in growth before reaching profitability. However, sustained negative retained earnings require attention, as they may indicate fundamental business challenges. Analysing why retained earnings are negative helps identify whether it's a temporary growth investment issue or a more serious profitability concern.

How do dividends affect Retained Earnings?

‍Dividends directly reduce retained earnings because they represent a distribution of profits to shareholders. When your company declares and pays dividends, that amount is subtracted from the retained earnings balance. This reduction reflects the decision to return capital to owners rather than reinvest it in the business.

‍Dividend policies vary significantly between companies. Growth-focused startups often reinvest all profits, resulting in no dividends and steadily increasing retained earnings. Mature companies with stable cash flows might pay regular dividends, keeping retained earnings relatively stable. Your decision on dividend payments versus retention should align with your growth strategy and shareholder expectations, considering both short-term rewards and long-term value creation.

What is the relationship between Retained Earnings and share capital?

‍Share capital represents the initial investment shareholders made in your company by purchasing shares, while retained earnings represent the profits the company has generated and kept after paying dividends. Together, they form the total shareholders' equity on your balance sheet. Share capital shows how much owners originally contributed, while retained earnings show how much value the company has created since inception.

‍As your company grows, retained earnings often become a larger component of shareholders' equity than share capital. This shift indicates that your business is creating value beyond the initial investment. Investors analyse this relationship to understand whether company growth is driven by ongoing profitability (retained earnings) or continued capital injections (share capital increases). A healthy growing company typically shows increasing retained earnings relative to share capital over time.

How do Retained Earnings influence business valuation?

‍Retained earnings significantly impact business valuation because they represent accumulated wealth within the company. Potential acquirers or investors examine retained earnings as evidence of your company's ability to generate and retain profits. High retained earnings suggest operational efficiency and financial stability, potentially justifying a higher valuation multiple during fundraising or exit negotiations.

‍However, exceptionally high retained earnings might also raise questions about whether the company is hoarding cash unnecessarily rather than investing in growth or returning it to shareholders. The optimal level depends on your growth stage and investment opportunities. Early-stage companies might maintain modest retained earnings while reinvesting aggressively, while mature companies might accumulate larger balances as financial reserves.