Topics Covered Hide
- Calculating retained earnings – The math
- Net gains and retained earnings explained
- Net losses and retained earnings – The connection
- Dividend payments and retained earnings in small details
- Other factors that can affect retained earnings
- Extra paid in capital made crystal clear
- Dividends explained – Their effects
- Dividends and share prices – Any connections?
- What makes retained earnings so important
- Repaying debt
- Spending money on marketing
- Upgrading current capital assets
- Moving on to new markets
- Holding money in a reserve fund
Now, the concept of retained earnings is self-explanatory and fairly simple to understand. These earnings are part of the net income, and they are normally retained by the management for all sorts of business-related operations.
Unlike most of the income or profit, these earnings are not paid as dividends to shareholders. Instead, they are most commonly held in a reserve fund. Sometimes, they are reinvested back into the business. Other times, they are used for debt or unexpected situations.
Again, retained earnings are not separate funds, but they are part of the surplus income – the profit. When profits go up, most shareholders get small parts as dividends. However, further growth requires further investment, and this is where retained earnings come in.
Just like you have probably guessed already, anything that will affect the business in terms of income will also affect retained earnings – sales, costs, revenue, expenses, depreciation, and so on. Now, to fully understand how retained earnings work, you need to become familiar with the factors behind them.
So, which of the following does not affect retained earnings? What affects this fund?
Calculating retained earnings – The mathRetained earnings are fairly simple to calculate. Most corporations rely on professional accounting services to perform such operations. If you have a small business, you will most likely be able to do everything yourself.
It all starts with the initial balance – if you have never bothered about retained earnings, your balance is zero. If you have done these things before, you should have a number – simply check the respective account.
Add the net income to this balance – it could be a loss if you had a bad year. Then, remove all the dividends paid before. The final number is what your retained earnings will look like once the last payment is made.
Retained Earnings Formula
Here is a simple example. Imagine you had $10,000 in your balance. Your net income is $6,000, and you pay $3,000 in dividends. To figure out the retained earnings, the formula is straightforward – 10,000+6,000-3,000, which leaves you with $13,000.
Overall, the formula is the same for everyone. But then, numbers will obviously differ from one company to another. Some companies pay more in dividends than others, not to mention profits varying widely – or perhaps losses.
Now, which of the following does not affect retained earnings?
Net gains and retained earnings explainedPeople will mostly be bothered about net gains. Now, no matter what events your business goes through, there will always be an impact on the retained earnings. It could be something small and insignificant – you may not even notice it. But it could also be something big that can skyrocket or ruin a business.
As your company is doing well, makes money, and earns income, retained earnings will inevitably increase as well. It makes no difference how your business makes money. It could be an income generated by selling a product or providing a service, but it could also be a capital stock investment.
Your retained earnings will carry over from the year before if you have failed to finish everything. They will keep adding, and no matter how tempting it is to invest straight away, a reserve fund can be helpful under certain circumstances.
Generally speaking, to see retained earnings increase, you will also need to see your income increase. You need to focus on good business and happy customers in one way or another – retained earnings will represent a positive consequence of your business.
Net losses and retained earnings – The connectionNet losses are similar to net gains, with one major difference – they go in the opposite direction. If net gains put money in your company or pocket, net losses will give you nothing – in fact, you may have to put money in yourself.
Now, there are a lot of events that can also lead to losses – in business, not everything is about gaining. Such events can cause losses in the cash flow, meaning retained earnings will also be negatively affected.
There are many such events of factors, but most commonly, having little to no profits is related to the costs associated with doing business. There are lots of expenses out there – mortgage or rent, your wages, or perhaps the necessity to buy particular supplies or goods needed to do business.
It makes no difference what products you sell or what services you provide. A loss will inevitably reduce retained earnings too. Anything that can be deducted from the cash flow will go into this category, even if those expenses are used in the business.
Dividend payments and retained earnings in small detailsDividend payments represent your pay, as well as other investors’ pay. However, there is a bit of controversy around dividends because people may end up disagreeing with each other – the last thing you want for your company.
All in all, paying dividends to stockholders will inevitably reduce the income as well. What does that mean? Exactly – retained earnings will be affected too. This is one of the factors that will actually affect your earnings in one way or the other.
Giving dividends implies rewarding people for their investments in the company. Different people invest for different rewards, but many of them do it to gain something in the long run – dividends are excellent, and they work like salaries, only they are never too consistent.
Prior to joining a business or establishing it, there must be a contract that defines dividends. These dividends are most commonly given over a percentage of the income. Obviously, they only pay if the company has enough retained earnings first.
Apart from retained earnings, equity will also be decreased due to paying dividends.
Other factors that can affect retained earningsRevenue and sales are obviously the most significant factors that will affect retained earnings. The more you sell, the more money you make, and the higher your retained earnings will be – it is just common sense. But what else?
The costs of the total goods you sold are not to be overlooked either. This is one of the direct costs and has a major impact on your income. It covers more aspects, though. For instance, you must count the materials you use to create goods. You also need to consider the actual labor expenses.
If you resell things, the original price and shipping costs must be added altogether.
Then, think about all the operating expenses. Again, many business owners overlook small details, but these costs can seriously affect retained earnings. All the formal and informal expenses must be added on.
They are more diversified and vary widely from one business to another. Think about rent and utility bills – or perhaps mortgage. Think about marketing costs and your employees, not to mention all the insurance policies you need. Development and research costs are just as important.
Fuel is another aspect that is often overlooked – even traveling to your business place is an expense.
Finally, depreciation is just as important. It affects plenty of businesses, even if their owners or managers fail to see it. Depreciation is the actual cost of a fixed asset, but it must be spread over its life as a useful piece of equipment. It makes no difference what it is.
Your retained earnings will be drastically affected by the net income and the dividends you pay to shareholders. As a direct consequence, things that will push the income or lead to losses will affect your earnings.
Now, each of these factors will give you different effects over the business retained earnings. The net income has a direct effect over the earnings. But other factors are indirect, so their relationship is not as obvious – causing inexperienced managers to overlook them.
So, which of the following does not affect retained earnings? Pretty much everything does, directly or indirectly. The way you conduct business is just as important, not to mention the relationship with your customers.
Extra paid in capital made crystal clearThe additional paid-in capital is another aspect that could have an effect over retained earnings. It is imperative to understand that it does not have a direct effect over these earnings, but it may lead to better results in the long run.
How? Simple. You get some extra money. You put it in. Make this investment the right way, and you should grow the business, improve an aspect in particular or even expand a little. It makes no difference how you use the money – if you do it right, your business will grow.
Now, additional paid-in capital is basically the capital generated by selling stocks or shares. You get such money by selling at the right price. You need to focus on the primary market and ensure the value matches your company needs.
This is when the par value kicks in – another concept that lots of newbies would fail to understand. So, what is this value about? This is the minimum value of a share and is determined by the respective organization when issued.
Now, if you issue shares for $2 each and you manage to sell them for $10 each, you obviously have some extra capital. The additional paid in capital for any share selling for $10 will be $8. This income is worth some consideration too.
Additional paid in capital can come from more direction. It is also considered as shareholder equity. Most companies get some income by issuing common stock. However, preferred stock is just as attractive. The number of shares you can sell will be directly proportional to the income – simple as that.
The consequence is fairly simple to observe. This extra capital is the equity available to support the growth. Then, expansion in one way or another will inevitably lead to higher sales if you do it right. Therefore, additional paid-in capital has an impact, but an indirect one.
Dividends explained – Their effectsThe dividend is practically the distribution of some of the income. These dividends are given to shareholders. Obviously, it is not like everyone can take whatever they want. These dividends are planned and determined by the board of directors.
Now, while this is not always a general rule, shareholders of companies that pay dividends are normally eligible if they had the stock before the ex-dividend time. Different companies pay dividends in different ways – money or perhaps extra stock.
So, the dividend is the distribution of profits to shareholders who are entitled to it. These payments have one purpose only – paying investors and rewarding them for trusting the initial idea and putting their money into the company.
When dividend payouts are announced, the stock price of the company will usually suffer a change. Usually, if it has been a good year, the price will obviously go up. Keep in mind that not all companies pay dividends – some of them retain the earnings. They are usually pushed back into the business.
Still curious which of the following does not affect retained earnings? Dividends make it pretty obvious – they do not. They have nothing to do with the actual retained earnings because they are paid from profits – if any, of course.
Dividends could potentially affect retained earnings if the company does not pay dividends. If the money is pushed back into the company for growth and expansion, there will be no dividends – meaning there will be more retained earnings too.
Dividends and share prices – Any connections?Dividends are not reversible. Once they are paid out, they cannot be sent back to the company. Sure, investors can choose to put more money instead, but these amounts of money normally mean one thing – cash goes out of the company books. They leave business accounts, and they are less likely to get back.
Dividends may not affect retained earnings directly, but they will definitely work on the share price. Share prices tend to go up based on the dividends declared. On the same note, share prices will go down at the next opening session.
For instance, imagine a company trading at $10 per share. The company then decides to declare a 3$ dividend. Once the announcement goes public, share prices will go up to about $13. If the stock trades at $14 before the ex-dividend date, the share price will be adjusted by $3 the next day.
In other words, the company starts trading at $11 then. After all, people buying on this date will not be able to get the dividend. This is the most common scenario out there, but there are situations when things could go in a different direction too.
What makes retained earnings so importantNow, you know what affects retained earnings. You know what affects the indirect ones too. Big companies are concerned about such things, while small companies run by families or single individuals find it too early to be bothered.
As you reach a particular level in terms of business, retained earnings inevitably kick in – they become a necessity. Some managers or entrepreneurs see them as a backup plan. You never know when you might need that money.
Each company will use retained earnings in different ways.
Repaying debtOvercoming debt is by far the most popular reason wherefore companies rely on retained earnings. It could be anything, but most commonly, it is a business loan. Whether it is something major or just a regular loan, it must be repaid – retained earnings represent the extra income leftovers that can be used.
Debt can come in more forms though, so a business loan is not the only reason wherefore, you should think about retained earnings. For instance, debt to suppliers can also be handled with retained earnings – as long as the company owes money, use this fund.
Extra dividends to investors
This is not a general rule – in fact, most companies will simply stick to the dividends they had agreed on before they started making a profit. However, there are situations when profits simply skyrocket for one reason or another.
Some companies totally smash their sales or come up with innovative techniques that will boost everything. At this point, some of them decide to pay additional dividends to their investors – nothing wrong with that.
Spending money on marketingIf there is no debt, retained earnings will most likely be used to expand the company and help it grow. At this point, there are numerous options for investment, and marketing is one of them. You are riding the wave, you got the money, and you want to take things further – marketing is the key.
Based on how small or large your company is, you can go in more directions. Large corporations go on live television. Small companies invest in other types of marketing or perhaps search engine optimization for a solid web presence.
Upgrading current capital assetsExtra money on your hands? If you think it might be time to upgrade the equipment, use the retained earnings to do it now. You never know what might happen by next year – you got the money now, so go for it.
The next year may not be as profitable as this one, hence the necessity to do it sooner rather than later. Even if your equipment does not need an upgrade straight away, if it is due for renewal in less than a year, you might as well do it now.
Investing in new capital assets
This might be the right opportunity to push things further by investing in new capital assets. There is always room for growth and expansion – new technologies, programs, software, solutions, products, features, and so on.
For example, you could get some new CRM software or perhaps a new and fully updated website.
Moving on to new marketsSpare money? Retained earnings often feel like a bonus. Everything is paid for. Suppliers are happy, employees are happy, and you keep making money. How about moving on to new potential markets then? There are lots of opportunities out there.
Some companies will expand a little and move towards different markets. Some others will keep it locally, but they will expand their actual operations. You can add new services to your offering or perhaps bring in some new products.
Holding money in a reserve fundUnless an expansion is mandatory or you have a very specific plan regarding the growth, you do not necessarily need to spend the retained earnings straight away. Obviously, it is not worth keeping money in an account for too many years either – inflation will slowly eat your money away.
However, lots of business people hold some reserves. An economic downturn could arise when least expected – take the recent coronavirus pandemic, for instance, not to mention the financial crisis from 2008. Potential future losses or a bad year can be covered this way.
Most commonly, the purpose of retained earnings is to help the business grow. Most of the additional profits will go back into the business and aim to increase earnings even more in the long run – assuming everything goes on according to the plan.
However, if the management does not believe that putting money back into the business will provide satisfactory returns for investors, those earnings can be distributed further on to shareholders – each company works in different ways.
ConclusionBottom line, which of the following does not affect retained earnings? There are clearly some factors that can affect retained earnings, such as the actual income – common sense. But then, some factors are direct, while others are indirect.
Somehow, everything revolves around how the company is run – the connection you have with your customers, the growth and expansion, successful deals, and so on. What you choose to do with the retained earnings depends on the further plans for the business.
Retained earnings do have their role, yet they are mostly useful for large companies.
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