Retained earnings refer to the portion of the earnings left with the company after the distribution of dividend to its shareholders. Retention of earnings is from the profits of the business for a financial year. A company cannot pay dividends or retain earnings in the case of net loss in any financial year.
Understanding Retained Earnings
In the case of profits, a company can use them to distribute dividend and provide a return to the shareholders. They can retain the balance portion of the earnings by transferring to reserves. The retained earnings add funds for expansion and build capital for the company. A company can reinvest a portion of its earnings into its business expansion plans.
The shareholders of a company invest, expecting a return on their investment. Certain shareholders expect dividend from the company as a return on their investment. In other cases, investors who trade in shares or invest for capital appreciation also expect dividend from the company.
In certain countries, dividends are tax-free, and in certain other cases, dividend gets taxed as per the tax slab of the recipient. However, returns in the form of stock sale giving rise to capital gains are taxed. In the case of companies which invest back their surplus net income, there is a high possibility of stock gains or capital gains.
The retained earnings could also be used for issue of bonus shares as a reward to shareholders. The issue of bonus shares is free of cost and thus results in gains for the shareholders. The management of a company may also use the retained earnings to buy back existing shares, thereby returning money to shareholders.
The management and the shareholders may have different views on the retention of earnings and using the earnings. The shareholders may like an annual return on their investment in the form of dividends. However, there may be a group of shareholders who like to reinvest and expand the business of the company for future appreciation in the stock price of the shares.
Hence, the management is likely to follow a balanced approach by paying a portion of the earnings as a dividend and keeping the balance as retained earnings.