Earned Surplus, also known as Retained Earnings, represents the portion of net income that a company retains rather than distributing as dividends to its shareholders. This cumulative total appears on the balance sheet under shareholders’ equity and is used for reinvestment in the business, such as purchasing new equipment, expanding operations, or paying down debt.
Importance in Financial Analysis
Business Growth and Expansion
Retained earnings are pivotal for funding internal growth without the need for external borrowing or equity financing. They allow companies to reinvest their profits into operations, research and development, or other strategic initiatives.
Financial Health Indicator
A growing retained earnings balance generally indicates a healthy, profitable company, suggesting to investors and stakeholders that the company is capable of generating profits and managing its resources effectively.
Calculation and Components
Initial Retained Earnings
This figure represents the cumulative retained earnings carried over from the previous fiscal period.
Net Income
The net income amount is added to the retained earnings, reflecting the company’s profit from operations during the accounting period.
Dividends Paid
Any dividends distributed to shareholders are subtracted from the company’s retained earnings, reducing the total available capital for reinvestment.
Example Calculation
Consider a company with:
- Retained Earnings (Beginning Period): $1,000,000
- Net Income: $200,000
- Dividends Paid: $50,000
The Retained Earnings would be calculated as:
Historical Context
Evolution of Corporate Finance
The concept of retained earnings dates back to the early 20th century, evolving alongside modern corporate finance. Previously, businesses relied heavily on external financing, but retained earnings emerged as a way to fuel internal growth and development, thus minimizing dependence on outside investors.
Applicability
Different Business Structures
While retained earnings are most commonly associated with corporations, they also apply to partnerships and sole proprietorships, albeit usually referred to with different terminologies and appearing differently on balance sheets.
Comparisons and Contrasts
Retained Earnings vs. Dividends
While both retained earnings and dividends come from net income, retained earnings are reinvested back into the company, whereas dividends provide immediate returns to shareholders.
Retained Earnings vs. Reserves
Retained earnings represent cumulative profits net of dividends, while reserves are portions of retained earnings set aside for specific purposes, such as contingencies or capital expenditures.
Related Terms
- Shareholders’ Equity: Represents the total net assets equity owners have in a company, including retained earnings, common stock, and additional paid-in capital.
- Net Income: The amount of profit remaining after all expenses, taxes, and costs have been subtracted from total revenue.
Frequently Asked Questions
Why are retained earnings important?
Retained earnings are vital for enabling a company to reinvest in its operations, pay off debt, and finance growth without relying on external funding.
How do retained earnings affect a company’s stock price?
Healthy retained earnings can positively impact a company’s stock price, signaling financial health and potential for future growth.
References
- Financial Accounting Standards Board (FASB). “Statement of Financial Accounting Concepts.”
- Investopedia. “Retained Earnings.”
- Harvard Business Review. “Retained Earnings and Business Strategy.”
Summary
Retained earnings, also known as earned surplus, play a critical role in a company’s financial strategy by providing the necessary capital for growth, expansion, and debt reduction. They serve as an indicator of a company’s financial health and its ability to generate and retain profits over time.
