Understanding Retained Earnings: Calculation & Significance

The level of a firm’s retained earnings is an important factor in its size, financial condition and growth rate. Simply put, retained earnings are the amount of net income that a firm retains in order to reinvest in its growth and operations. The portion of net income that is not kept by the company is paid out as dividends to shareholders. Hence, dividends paid out plus retained earnings equals net income. The percentage of net income that is retained by the firm is called the "earnings retention rate."

Size of a Company in Relation to Its Retained Earnings

The reason that smaller, newer companies tend to have higher growth rates is that a higher percentage of net income is reinvested into the firms. Because smaller companies do not pay dividends, 100 percent of net income is reinvested as retained earnings, which accelerates growth. Larger and more mature companies, though, are known for having larger dividend payouts because the use of retained earnings as a source of capital for growth becomes diminished once a firm reaches a certain scale. At this more mature stage, higher dividend payouts keep investors happy at a time when raising capital by issuing equity becomes a more efficient way to fund and maintain growth.