Retained Earnings: Definition, Calculation & Significance

Retained earnings is the amount of money that a corporation keeps of its profit instead of distributing it to the shareholders in the form of dividends. How much money a company retains can tell you a lot about them and what they are trying to accomplish. This is also sometimes referred to as the retention ratio or the retained surplus.

Retained Earnings

The process of calculating the retained earnings of a company is relatively simple. In order to calculate the retained earnings of a company, you take the beginning retained earnings and add to that the net income of the company over a particular period of time. Then you subtract from the number the amount of dividends that were paid during the time period. The amount of money that is left over represents the retained earnings. 

Trying to Grow

If a company keeps a great deal of its profits for retained earnings, this is usually a good sign that they are trying to grow the business. If you are interested in growth stock, this type of company would usually be what you are looking for. When a company keeps a lot of its profit, they are most likely looking to expand into new areas. They can potentially use this money to build a new facility or invest in research and development.

Low-Retained Earnings

There are also many companies out there that have very low amounts of retained earnings. Instead of keeping money for themselves, they divide it up in the form of dividends for the investors. Typically, these companies are very well-established and have been around for an extended period of time. When you invest in this type of company, you can generally count on large dividend payments on a regular basis. These types of companies are ideal for retirees or other individuals that want to create a residual source of income.

Efficiency

As an investor in a company, you need to evaluate how efficient the company is that using the retained earnings. If a company is not going to issue the money out to you in the form of a dividend, you want to make sure that they are using the money for the best purpose. You need to see that the retained earnings are being turned into capital appreciation and more profit for the company in the future. 

In order to do this, you can compare the amount of profit against the percentage change in profit over a specific amount of time. This is typically done on a per share basis to keep things simple. If the value of the profit per share increases by a large percentage in comparison to other companies within the same industry, then the company is doing a good job with its retained earnings.

You can also look at the impact of the market value of the retained earnings. You can look at how much the price of the company's shares increased compared to the amount of money that was retained per share.