2 min read
When it comes to profit, you have options. Some profits are used to finance daily operations, while others are paid out to shareholders as dividends. But what is retained profit, and why would a business choose to hold on to a percentage of its profits? Here’s what to know about the advantages and disadvantages of retained profits in business.
What is retained profit?
Retained profit, or retained earnings, is the portion of a business' earnings that it keeps after taking shareholder dividends into account.
It is calculated using net income, net income brought forward, and dividends (cash and stock). Retained profit is important to understand for investors as an indicator of a business’s financial stability.
Operational profits can be used in numerous ways. While corporate taxes are obligatory, there are some decisions to be made regarding what to do with the remainder of the profit. Any earnings kept on the books after tax and dividends are paid out qualify as retained profit.
Retained Profit formula
Understanding retained profit and what it means for you
While not all businesses turn a profit, those that do must plan what to do with it. In fact, determining whether to use retained profit is one of the most important decisions you can make.
You have three primary options:
Take the profit as personal income
Take the profit out as shareholder payments
Use retained profit for reinvestment in your business
To use this term in accounting, a company has the option of bringing forward its retained profit from one period to the next. This is called ‘retained profit brought forward’ on financial statements.
Retained profit: formula and example
If a business has earned £3,000 in retained profit for two years in a row, the retained profit brought forward for the third year would be £6,000.
Advantages of retained profit
There are several advantages of retained profit which make it a popular option for long-term financing.
1. Increased stock value
Keeping your company earnings increases your balance sheet, which has a knock-on effect to stockholder equity and corresponding stock value. Retained profit makes your business look better on paper with more money in your accounts, in turn attracting further investment.
2. Financial safety net
Holding onto excess profit also boosts your corporate liquidity. This lends stability to your business with a financial safety net for any unexpected expenses. Should emergencies arise or the market take a turn for the worse, your business has money in the bank to access without taking on new liabilities.
3. Funding for growth
Another advantage to retaining profit is it gives you a fund for research and development. You can reinvest your earnings into the company and drive growth. Retained profit can be brought forward for multiple years to amass funding for reinvestment.
Are there any disadvantages to retaining profit?
While on the surface retaining profit seems like a good way to increase company value and save money for reinvestment purposes, it’s not always the most efficient option. One thing to consider is the cost of borrowing. Interest rates might be more advantageous when borrowing money rather than relying on growth rates of existing profit.
Another factor to consider is that retaining profit isn’t always the most popular option among a company’s shareholders. Shareholders often prefer to receive higher dividends rather than see the money reinvested to increase stock value. This can potentially make your company less attractive to investors, although this will depend on their investment habits.
The bottom line
As you can see, there are pros and cons to retained profit. Advantages include the ability to boost value and set aside funding for emergencies. Yet on the other hand, disadvantages of retained profit include potentially turning off shareholders by retaining money that could be used for dividends. The best course of action will depend on your financial obligations and future goals.
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