Retained earnings are profits that a company doesn’t pay out as dividends to investors, but instead reinvests in the company to pay off debt or invest in future growth, leading to higher earnings and a healthier corporation.
Sometimes referred to as earned surplus, retained earnings are income or profits that are received by a company, but are not paid out as dividends to the company’s investors. There are several reasons why retained earnings are important to the financial stability of many corporations. Here are some examples of how retained earnings can be an asset in business operations.
The key point to remember about retained earnings is that earnings represent revenue generated by the business. More importantly, retained earnings illustrate that the company is earning a profit that is capable of generating dividends for investors. The fact that the company is successful enough to pay dividend benefits to investors is one way of demonstrating a healthy corporation.
However, instead of paying dividends to investors, retained earnings are reinvested in the company in two ways. First, the non-appropriate benefit can be used to pay any outstanding debt that the company currently has, such as loans or other obligations. Because retained earnings represent funds that are not needed to cover the company’s regular operating expenses, choosing to use earnings to pay off outstanding debt can often make a good situation even better. Less outstanding debt translates to a higher profit margin for years to come.
A second common use for retained earnings is to take the money to buy upgraded equipment or finance a project that will improve the company’s ability to be profitable. For example, the proceeds can be used to purchase new equipment for the operation or to finance a marketing campaign for a new product or service. Using retained earnings to invest in the company’s future often leads to higher earnings for the corporation over time, which in turn will lead to more retained earnings for years to come.
While paying dividends is often an important part of running a business, many investors are more than willing to forego receiving a small dividend today in anticipation of receiving a larger return on investment in the future. After all, ensuring the financial and operational health of the corporation will mean that the initial investment will pay off and not be lost to corporate failure. By allowing retained earnings to be used to reduce or eliminate current debt or as an infusion of cash to fund a new marketing campaign, the chances of a higher return on investment are much greater. As any investor understands, higher returns are always desirable.
Smart Asset.
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