Retained earnings are the profits generated by a company that are not distributed as dividends to the shareholders. The retained earnings are the sum of profits that have been retained by a company since its inception. They are reduced by the losses. Retained earnings are also known as accumulated surplus, accumulated profits, accumulated earnings, undivided profits and earned surplus.
When a company makes profits, the board of directors has two choices. It can either distribute these profits as cash dividends or it can retain these profits and reinvest them for future growth. A company may retain its profits in a reserve to serve some specific objectives. For example, a company may retain its profits to create a reserve for paying off a debt or for purchasing an expensive capital asset.
It is important to note that the retained earnings do no represent surplus cash left after payment of dividends. Instead, the retained earnings show how the company has treated its profits. They represent the amount of profits a company has reinvested since it was incorporated. The reinvestments are either purchases of new assets or reductions in liabilities.
Ideally a company should retain its profits if it can generate higher return for the shareholders by reinvesting the profits. If it retains the profits but does not experience a satisfactory growth rate, it should better pay off the profits as dividends. The goal of any successful management should be to generate $1 in market value for every $1 of retained earnings.
Retained earnings represent the dividend policy of a company because they reflect a decision of a company to either reinvest the profits or to distribute profits. Therefore, most analyses try to evaluate which action created or would create higher value for the shareholders. This evaluation can be done by comparing the retained earnings per share to earnings per share, or by comparing the amount of capital retained to the changes in the share price.
Retained earnings are affected by the nature of industry and the age of company. Capital intensive industries and growing companies tend to retain more of their earnings because they need assets to operate. Older companies may have significantly larger amounts of retained earnings than identical younger companies because retained earnings represent profits retained since the inception of a company.