The accounting concept, retained earnings, is important for any company. But what exactly is it? And as an investor, how can you use it to measure a company's viability as an investment? Let's take a closer look at this simple but important measure.
What is retained earnings?
Retained earnings is best explained with a simple formula:
- Net income - dividends + retained income from prior years = retained income
Let's assume, for instance, that Company X ends its fiscal year with $10 million in retained income on the books. Now let's say Company X reports a net income of $2 million at the end of the year but then pays out $1 million in dividends to shareholders. The net result is that Company X now has $11 million in retained earnings.
What retained earnings isn't
Retained earnings is not a company's current cash or cash-equivalents.
It's a running historical tally of net earnings not paid out to shareholders. All of a company's retained earnings end up in two places: cash or equivalents (including marketable securities), or invested back into the business.
Depending on the company, retained earnings should grow significantly over time, but this should also be reflected in increased assets, as the company uses retained earnings to invest in new equipment and property, develop new technology, and acquire competitors. These things (in theory, if not always in practice) add value to the business and make its ability to generate profits stronger.
So to summarize, cash is often a product of retained earnings, but it's not where most of those retained earnings will end up over time as companies reinvest earnings in the business.
The other side of retained earnings
Apple and General Mills are both established companies with long track records of consistent profitability, as their massive running tally of retained earnings shows. However, newer companies that may be spending more than they are bringing in to develop a market or expand their business may carry a negative retained-earnings number.
In this case, it's called an accumulated deficit.
These accumulated losses can have value for a company, by way of a "loss carry-forward" for the purpose of offsetting future taxes. Depending on the specifics, a company can use accumulated losses for as far back as seven years to reduce income tax expenses, by incorporating prior years' losses to later profitable years.
Putting it all together
Essentially, retained earnings and the inverse, accumulated deficit, are a running tally of a company's historical profits kept after paying out dividends. It's reported in a company's quarterly 10-Q and annual 10-K SEC filings, under the "stockholders equity" section of the balance sheet.
If there's one measure that it can help with, it's looking for companies that should be able to sustain and increase their dividends. If a company has a relatively high amount of retained earnings -- specifically, retained earnings growth over recent years -- this should indicate a company that can at least sustain its dividend, and probably grow it. If retained earnings haven't grown much in the past few years (of course factoring in macroeconomic conditions), then it might indicate a company with limited ability to increase payouts.
Since retained earnings is a long-term measure, it's really not very handy on its own and must be used within the context of the company's more recent results as well as its future prospects. Furthermore, it's only one metric. Never rely on any one number to measure a company.
Jason Hall owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.