What Retained Earnings Mean for Your Business?

May 9, 2024

An image of small business owner reviewing their retained earning.

Profits are a key motivation for any for-profit business. Many business owners feel that sales growth and profitability make their business successful. But when you look at your business from an investor’s perspective, you realize profit alone is insufficient. How you use your profit and compound your earnings defines business success and failure. You also learn from retained earnings – the consolidated surplus income after tax your business has earned since inception. 

What Are Retained Earnings?

Net income attributable to shareholders shows the company’s profit after all expenses, including the business owner’s salary. Business owners decide whether to withdraw more profits through dividends or retain that income in the business. 

Retained earnings = Opening retained earnings + net income/loss – dividends

Since tax is already paid on retained earnings, there is no tax liability. However, if you withdraw them as dividends, they are taxable in the hands of the shareholder.

The statement of retained earnings states the accumulated earnings since inception. It shows whether the owner is withdrawing all the profits as dividends or is reinvesting in the business for growth. A successful business adopts a balanced approach towards dividends and reinvestment.  

How Business Owners Can Use Retained Earnings Effectively 

How can a business owner use this money effectively when balancing retained earnings? Retained earnings are like the company’s savings, which have no dedicated purpose. You can use them as per your business requirements. 

Reinvest in the business: If you plan to expand or take up more orders, you need capital. You can fund the new equipment, a marketing campaign, or a new store from your retained earnings. And if you need a loan, banks will look at your positive retained earnings, among many things, to sanction loans. However, do not forget to pay yourself for the efforts you are putting in as a business owner. Make sure to give yourself a salary instead of only paying dividends. 

Repay loans: Sometimes, you may not have any business opportunity to invest. You could consider using some of your retained earnings to repay debt and reduce interest payments. Saving up on interest expenses will improve the company’s retained earnings.

Financial cushion: Every business has ups and downs. The profits earned in the upturn can help you sustain yourself during the downturn. Ensure you have enough retained earnings to give you a financial cushion during crises. 

Investing: You could consider investing your retained earnings in stocks and bonds to diversify your income stream and earn better returns. 

You can allocate your retained earnings in one or more of the above uses depending on the need of the hour and assessing the opportunity at hand. The objective of retained earnings is to give you the flexibility to never miss out on opportunities. 

What Retained Earnings Say About a Company’s Finances? 

A company with zero retained earnings is like living paycheck to paycheck without emergency funds, savings, or investments. Such companies have limited financial flexibility and are likely to take a bigger hit in times of crisis. While retained earnings give businesses financial flexibility, they also make it easy to procure funding from investors. 

Banks look for at least two years of positive retained earnings before giving a loan. Even investors look at retained earnings as they show the business owner’s intent to grow the business. Many lifestyle businesses do not attract investors, as the owner withdraws all the profit to maintain his/her lifestyle. 

When reviewing the retained earnings statements, investors examine the retention ratio, the percentage of profits retained in the business. There is no such thing as a good or bad ratio, but what draws attention is the consistency in the ratio. 

For instance, John earned $100,000 in net income, retained $60,000 and withdrew $40,000. His retention ratio is 60%. In the first year of business, it was 60%. Next year it was 10%, another 10%, and the following year 50%. This lack of consistency draws investors’ attention. While fluctuation is regular, such sharp ups and downs give the impression that the business is not systematic and has no roadmap for future growth. 

Should You Be Alarmed About Negative Retained Earnings? 

While positive retained earnings instill confidence, consecutive negative retained earnings could sound alarm. A new business may have negative retained earnings as it has been making losses in the initial years. However, these numbers should turn positive at some point. Otherwise, it shows that the business is only accumulating losses. At times like these, a business owner could consider restructuring to streamline the operations and focus on growth and profitable ventures. 

Contact KSSP Partner LLP in Markham to Help You with Financial Statements 

A professional accountant can help you prepare your retained earnings statements and guide you in improving them. They can also help you procure investments by making financial statements and reports investors and banks seek. To learn how KSSP Partners LLP can provide you with your financial statements, contact us online or by telephone at 289-554-5997.