What Do Your Retained Earnings Tell About Your Business?

Earnings are important indicators of how well your business is doing. You can report them as a net profit or loss. Calculating your earnings helps you make the right decisions about the future of your business. Businesses do not just do well; many factors contribute to their success. One of those factors is how companies spend their retained earnings based on the decisions made by the business owner and the management team.

This article presents the key points for business owners considering using their retained earnings to grow their business.

What Are Retained Earnings?

Retained earnings are profits a company holds onto after paying all its expenses. Business owners use them to pay dividends to shareholders or reinvest in the business for growth and expansion. The more a business invests them, the more profits it makes. Therefore, they are essential measures of a company’s financial health.

How Do They Work?

To understand how retained earnings work, you must consider a company’s balance sheet and income statement. They give the framework for understanding how earnings work. The balance sheet is a snapshot of all the assets, liabilities, and equity that a business has on record at a certain point in time. The income statement measures how profitable (or unprofitable) the company is over time.

Retained earnings make up the difference between the company’s net income and dividends. For example, if a business makes USD$10 million in net income but only pays out USD$5 million in dividends, it has retained earnings of USD$5 million. A company can also use them to pay for expansion or cover losses incurred by other businesses it owns.

What Retained Earnings Say About Your Business

Retained earnings comprise an integral part of a business’s value. They are symbolic and indicative in the following ways:

Business Profitability

Retained earnings measure of how profitable a company is. The more you reinvest them into your business, the higher they will be. This shows investors that you are making good use of their money, and they want to invest in your business even more.

Business Growth

You can also use retained earnings to measure business growth. To do this, you compare the current total to those of the previous year. If there has been an increase in them over time, your business is growing. You can use this information to decide whether investing in a new project will benefit your company finances.

Business Valuation

Retained earnings are used to calculate the value of a business. To do this, you divide the total retained earnings by the number of outstanding shares. This gives you what is known as a price/earnings ratio (P/E) which is then multiplied by 100 to get your valuation.

For example, if you have USD$50 million retained earnings and 20 million shares outstanding, your P/E ratio would be 2.5 (USD$50 million ÷ 20 million). Multiply that by 100 to get your valuation of USD$250 million.

Business Stability

You can also use retained earnings to measure business stability. If they are negative for your company, you have a loss in capital. This means you need to invest more money into your business. Consider selling assets or making cuts to increase your stocks again.

If your company has positive retained earnings, it means that you have a gain in capital and can use the money to pay off debts or invest in other projects.

Business Liquidity

You can also use retained earnings to calculate business liquidity. This measures how much cash is available in your company and helps you determine whether you should borrow money. The formula for calculating business liquidity is as follows:

Liquidity = Retained Earnings – Cash and Short-Term Investments

Next, divide this amount by the total amount of stock. The result will tell you how many years it would take for your company to go bankrupt if all revenue suddenly stopped flowing in.

How Do They Attract Investors?

The following are ways retained earnings help attract investors to your business:

1. Allowing you to pay less interest on loans you take out;
2. Showing your business is profitable and has a good chance of staying in business for the long term;
3. Making it easier for investors to calculate how much money they’ll make from investing in your business; and
4. Providing evidence that your company’s earnings will continue to grow.

Conclusion

Retained earnings are essential aspects of running a successful business. They tell you how much money has been invested in your company since its inception and how much it has grown over the years. Moreover, they give you an idea of how well your company is doing financially and whether or not it is likely to continue growing at its current rate.