Retained Earnings: The Profit a Company Chose to Keep

Retained earnings are the accumulated profits a business has kept rather than paid out to its owners. The balance rolls forward: opening retained earnings plus the year's profit less any dividend gives the closing figure. Retained earnings are not a pile of cash. The money they represent has usually been spent on inventory, receivables and equipment, so a business can hold large retained earnings and still be unable to pay a dividend.

Here is what sits underneath that. Profit belongs to the owners of a business from the moment it is earned. The owners can take it out, or they can leave it in. Retained earnings is the single line that records how much of it they have left in, added up over the whole life of the company rather than over one year. Nothing about that line says where the money went afterwards, and that silence is where almost every misreading of it starts.

Anjani Stationers, an invented stationery supplier, took its retained earnings from an opening Rs 72,00,000 to a closing Rs 1,02,00,000 with nothing deducted on the way, and ended the year with Rs 5,00,000 in the bank. One balance sheet carries the whole subject: where a crore of accumulated profit is actually sitting, which lines a dividend touches and which it leaves alone, and why a shareholder looking at Rs 1,02,00,000 of kept profit cannot be written a cheque for a fraction of it.

What are retained earnings, and how are they different from profit?

Profit is a figure for one stretch of time. Retained earnings is a figure at one date, and it holds every stretch of time the business has ever traded through. The two are often quoted in the same breath as though they were the same quantity measured twice, so the difference is worth getting straight before anything else.

Profit answers what this year produced. Retained earnings answers what every year put together has left behind after whatever the owners took out. A household with one earning member shows the difference. The salary credited this month is profit: it describes one month and nothing else. The balance built up in the savings account after years of spending some and keeping some is retained earnings: it describes a position today, it carries the whole history, and it says nothing at all about which month was good. Asking how much came in last month gives one answer. Asking how much has been kept altogether gives a completely different one. Anjani Stationers earned Rs 30,00,000 of profit after tax in year two. Its retained earnings on 31 March of year two are Rs 1,02,00,000. Both numbers are correct and they are answering different questions.

The word doing the heavy lifting is accumulatedAdded up over every period since the beginning rather than measured for one period, so the figure carries the whole history in a single number.. Retained earnings never resets. Every profitable year pushes it up, every loss-making year pulls it down, every payment to owners pulls it down, and the balance simply carries on from wherever it was. A company that has traded for twenty years shows one number that twenty years produced, and the balance sheet does not break those years out.

How does the balance roll from one year to the next?

By one line of arithmetic that never changes. Take the opening balanceThe amount a line stood at on the first day of the period. It is always the same as the amount it closed at on the last day of the period before., add the profit the year produced, take off whatever was paid out to owners, and what is left is the closing balance. The closing balance becomes next year's opening balance, and the chain runs on for as long as the business does.

Opening retained earnings plus profit for the year less dividend equals closing retained earnings, and every retained earnings figure on every balance sheet ever published was produced by that one subtraction. The name for working a balance through in this way is a roll forwardShowing how a balance moved from the start of a period to the end of it by listing every addition and subtraction in between. The two ends are then joined by visible arithmetic rather than asserted., and it is the single most useful habit in reading accounts. It turns two unexplained numbers into one explained movement. Anjani Stationers opened year two with retained earnings of Rs 72,00,000. The year earned Rs 30,00,000 and nothing was paid out. So the balance closed at Rs 1,02,00,000, and there is nowhere else that figure could have come from.

Companies set this out formally in a statement of changes in equityA short statement that shows how each part of equity moved from the opening date to the closing date, listing every addition and deduction rather than only the two end balances.. The statement of changes in equity is the roll-forward presented on its own in the accounts. Anjani Stationers' appears below in its simplest form, with share capitalThe amount the shareholders originally put in for their shares, recorded at the face value of those shares and left sitting unchanged unless new shares are issued. beside retained earnings so that both halves of equityWhat is left for the shareholders once everything the business owes has been deducted from everything it holds. On this balance sheet it is share capital plus retained earnings. can be followed at once.

Why are retained earnings not a pile of cash?

Because retained earnings is a line on the funding side of the balance sheet, and cash is a line on the asset side. The two lines answer two different questions. Retained earnings says where a part of the money came from. Cash says where a part of the money currently is. Reading the first as though it were the second is the most common single error made with this line, and Anjani Stationers shows it at full size.

The accumulated profit was long ago turned into Rs 86,00,000 of unpaid customer invoices, Rs 28,00,000 of notebooks in the godown and Rs 36,00,000 of equipment, so Anjani Stationers holds Rs 1,02,00,000 of retained earnings and Rs 5,00,000 of cash on the same morning. Picture a shopkeeper who has done well for fifteen years. Ask the shopkeeper how much the shop is worth and the answer is large. Ask how much is in the cash box on a Tuesday afternoon and the answer is small. The money went into stock on the shelves, into the delivery scooter, into the shop credit extended to the school down the road. Nothing has gone wrong. A business that kept its money in the box would not be a business, so the money simply is not in the box. Anjani Stationers is that shop with two more zeroes on every figure.

What is a dividend, in balance sheet terms?

A dividendA payment a company makes to its shareholders out of profit, distributed in proportion to how many shares each of them holds. is the owners taking some of the kept profit back out, and nothing more. The shareholders decide that a part of what has accumulated should stop being funding for the business and start being money in their own hands, and the company pays it across in proportion to how many shares each of them holds.

A dividend is a movement out of the business, not a cost of running it. So it is deducted inside the roll-forward of retained earnings and never appears as an expense anywhere. Hold on to the difference. The difference decides what a dividend does to each of the three statements. Paying the electricity bill is a cost of earning the year's revenue, so it belongs on the statement of profit and loss and it reduces profit. Paying a dividend is what the owners choose to do with profit after the year has already been measured, so it belongs after the profit figure has been struck and it reduces nothing except the accumulated balance and the bank. A wedding is a useful picture here. The catering bill is a cost of holding the wedding. The cash gift handed to the couple afterwards is not a cost of anything, it is a transfer of money that was already there.

How Dividends Affect Financial Statements: what changes on each one?

The question is almost always asked one statement at a time, so take it one statement at a time and answer without hesitating. There are three answers and only two of them involve a number moving.

On the statement of profit and loss, nothing changes. Revenue is unchanged, every expense line is unchanged, and profit after tax is unchanged. The dividend is a decision taken about profit rather than a cost incurred in earning it, so a dividend of any size leaves that statement exactly as it was. On the balance sheet, two lines move and they move by the same amount: cash goes down by the dividend paid, and retained earnings goes down by the dividend paid. Total assets fall, total equity falls, and the balance sheet still balances because both sides fell together.

A dividend takes the same amount off cash on the asset side and off retained earnings on the funding side, leaves profit untouched, and therefore cannot make a balance sheet stop balancing. Work it through on Anjani Stationers with an amount small enough that the mechanism shows before the money runs out. Suppose Rs 4,00,000 had been paid. Cash falls from Rs 5,00,000 to Rs 1,00,000, so total assets fall from Rs 1,80,00,000 to Rs 1,76,00,000. Retained earnings falls from Rs 1,02,00,000 to Rs 98,00,000, so equity falls from Rs 1,42,00,000 to Rs 1,38,00,000. Check it: Rs 1,76,00,000 of assets less Rs 38,00,000 of liabilities is Rs 1,38,00,000 of equity. Profit after tax for year two is still Rs 30,00,000, and it would still be Rs 30,00,000 whatever the dividend had been.

Why can a profitable business be unable to pay a dividend?

Because two completely different tests have to be passed and only one of them is about accumulated profit. The first test asks whether there is enough kept profit to draw on, and that is answered by the retained earnings line. The second test asks whether there is any money to hand over, and that is answered by the cash line. A company can pass the first test by a mile and fail the second one by a mile on the very same morning.

Whether a dividend can be paid is decided by the smaller of what the accumulated profit allows and what the bank balance can supply, and for Anjani Stationers those two ceilings are Rs 1,02,00,000 and Rs 5,00,000. There is a third ceiling as well, set by the law, and its height depends on the Companies Act rules for the year concerned. Set the three side by side and the answer is immediate. The accumulated profit permits a very large payment. The law permits some amount that has to be read at the source. The bank holds Rs 5,00,000, and no arrangement of the first two ceilings can turn Rs 5,00,000 into more than Rs 5,00,000. DistributableDescribing the part of accumulated profit that a company is legally permitted to hand over to shareholders, It is not necessarily the whole of the balance, and it is not the same thing as having the money to hand. profit and payable profit are two separate ideas, and a reader who collapses them will misread this balance sheet every single time.

What did Anjani Stationers do with its Rs 30,00,000?

Anjani Stationers kept all of it. Anjani Kulkarni declared no dividend in year two, so the whole of the Rs 30,00,000 of profit after tax went into retained earnings and the balance closed at Rs 1,02,00,000. A dividend that was never declared can still be worked through beside that fact, to show the roll-forward with a deduction in it.

Anjani Stationers paid no dividend at all in year two, and the reason is sitting on the same balance sheet: Rs 5,00,000 of cash against Rs 86,00,000 of unpaid invoices and Rs 28,00,000 of unsold notebooks. Now suppose a dividend of Rs 10,00,000 had been declared. Retained earnings would have closed at Rs 92,00,000 rather than Rs 1,02,00,000, and equity at Rs 1,32,00,000 rather than Rs 1,42,00,000. The statements would have said exactly that. The bank is a separate matter: it held Rs 5,00,000, so it could have supplied half the payment and no more. The dividend was never declared and never paid. The year two accounts of Anjani Stationers show nil on that line, and the Rs 10,00,000 only illustrates the roll-forward with a deduction in it.

Four settings carry the whole lesson. At nil the sheet is the reported one: retained earnings Rs 1,02,00,000, equity Rs 1,42,00,000, cash Rs 5,00,000. At Rs 5,00,000, the whole bank balance handed over at Rs 1.25 a share, retained earnings falls to Rs 97,00,000, equity to Rs 1,37,00,000 and cash to nil. Rs 5,00,000 is the last amount that can actually be paid. At the stated hypothetical of Rs 10,00,000 the statements would read Rs 92,00,000 and Rs 1,32,00,000, and the bank would be Rs 5,00,000 short. At Rs 30,00,000, the whole of the year's profit, retained earnings would fall back to its opening Rs 72,00,000 and equity to Rs 1,12,00,000, with the bank Rs 25,00,000 short. Assets and equity always fall by the same amount, so the arithmetic never breaks at any setting. Arithmetic alone can therefore never settle whether a dividend is payable.

How does a lender actually read the retained earnings line?

Outside the classroom, this line is not an idea people admire. The line is a tool people use in rooms where money is being decided, and three different readers pull three different things out of it. None of them reads it as a cash balance, and all of them read it against something else on the same balance sheet.

A lender reads retained earnings against share capital to see how much of the equity the business built for itself, and Anjani Stationers built Rs 1,02,00,000 of its Rs 1,42,00,000, or 71.8 per cent. That ratio is doing real work. Equity of Rs 1,42,00,000 could have arrived in two completely different ways. The equity could have been subscribed by shareholders writing cheques, in which case the business has proved nothing about its own trading. Or it could have been earned and left in, in which case fifteen years of profitable trading are sitting in that number. Anjani Stationers is overwhelmingly the second kind, and a lender treats that as evidence rather than as capital. An analyst does something different with the same line: it is the anchor of book valueThe value of a business as its own balance sheet reports it, being everything held less everything owed. It is a record of what was paid and kept rather than an estimate of what anything is worth today., and dividing equity of Rs 1,42,00,000 by 4,00,000 shares gives Rs 35.50 a share, of which Rs 25.50 is accumulated profit and Rs 10.00 is the original share capital. A shareholder deciding whether to expect a payment reads it in a third way, and the honest answer is that they should read the cash line instead.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited, Anjani Kulkarni, Meera Rao and the Sunrise Public School group are invented.
Educational material. Not advice on any investment, tax, budget or market position.