What is Retained Profit in Accounting? Definition, Formula and Calculation
Retained Profit Definition
Retained profit is the remaining amount of net income that is kept within the business after any dividends have been paid out to shareholders.
In simpler terms, it represents the profits reinvested back into the company rather than being distributed to shareholders as dividends.
Retained profit is also known as retained earnings or accumulated earnings.
What is Retained Profit Used For?
Retained profits can be used for variety of reasons within a company, including:
Reinvestment in the Business
Retained profit can be reinvested back into the business for growth initiatives.
These funds could be allocated towards research and development, purchasing new equipment or expanding and scaling operations.
Debt Reduction
Businesses might use retained profits to pay down debt which can reduce their interest expenses and improve the company’s future cashflows.
Emergency Fund
Retained profits can also be used to increase a business’s cash reserves, which can serve as a financial cushion from periods of economic downturns or unforeseen expenses.
This cash buffer can help the company navigate any potential financial challenges without having to use external financing or take drastic cost-cutting measures.
Acquisitions
As part of strategic growth plans, businesses may use retained profits towards acquiring other businesses.
Share Repurchases
Some companies use retained profits to buy back their own shares from the market, which can help boost the value of remaining shares and improve earnings per share metrics.
Retained Profit Formula
Calculating retained profit involves a straightforward formula:
Retained Profit = Net Income – Dividends
Where:
Net Income is the total revenue earned by a company minus all expenses, taxes, and interest.
Dividends are payments made to shareholders as a distribution of profits.
How To Calculate Retained Profit
Let’s now look at how to calculate retained profit, through a theoretical example:
Imagine a company has the following financial information at year end:
Net Income | £700,000 |
Dividends Paid | £200,000 |
Retained Profit = £700,000 – £200,000
Retained Profit = £500,000
Therefore, over the financial year, the company kept £500,000 in profits for reinvestment or future use.
Advantages of Retained Profit
Retaining profit has several advantages for businesses:
Financial Flexibility
Retained profits provide a source of internal funding that allows a company to pursue opportunities without relying on external financing.
For example, this flexibility can be used to pay down debt which will reduce interest expenses and improve the company’s overall financial health.
Investment in Growth
By retaining profits, a company can reinvest them back into the business for growth initiatives such as research and development, developing new products or services, entering new markets, or acquiring other companies.
This reinvestment can lead to increased market share, revenue, and profitability over time.
Financial Cushion
Retained profits can just be kept as a financial buffer, and used if the company experiences any unexpected expenses or periods of financial strain.
Having an adequate cash reserve allows the company to maintain normal operations without the need to look for external financing.
Disadvantages of Retained Profit
However, for balance, retaining profit also has several disadvantages for businesses:
Dividend Expectations
Shareholders, especially those who rely on dividend income, may become dissatisfied if a company consistently retains profits instead of distributing dividends.
Failure to meet dividend expectations could lead to a decline in investor confidence and potentially result in a decrease in stock price.
Overcapitalisation
Retained profits that are not effectively reinvested or distributed to shareholders can lead to overcapitalisation, where a company accumulates excessive cash reserves or assets with low returns.
This can reduce the company’s overall efficiency and return on invested capital.
Market Perception
Investors and analysts may interpret a company’s decision to retain earnings instead of paying dividends as a signal of limited growth prospects or uncertainty about the company’s future profitability.
This can negatively impact the company’s stock price and market valuation.