Page 67 - Finance for Non-Financial Managers

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Finance for Non-Financial Managers
48
Retained Earnings
Every company, from its inception, develops a history of profits
and losses. Profits add to retained earnings and losses reduce
retained earnings. If a company has operated with overall prof-
itability, it will have accumulated a substantial amount of earn-
ings over time. If it is a proprietorship (unincorporated, one
owner) or a partnership (unincorporated, two or more owners),
these earnings are usually taxable to the owner(s) immediately,
so they are typically paid
out to the owner(s) each
Retained earnings Profits
of a business that have not year, as dividends or distri-
been paid out to the own- butions of profits.
ers or stockholders (as dividends) as However, if the compa-
of the balance sheet date.These earn- ny is a corporation, its
ings are reinvested in the business. owners will not generally
be taxed on the compa-
ny’s accumulated profits until the company chooses to distrib-
ute those earnings to its owners in the form of cash dividends.
In the interim, the accumulated earnings not distributed to its
owners are shown as, logically enough, retained earnings.
Earnings are retained in the business for other reasons than
just to avoid paying taxes on them, including enabling the busi-
ness to retain cash for expansion or to purchase land, buildings,
and equipment (fixed assets) to facilitate its operations. The
company may also be building a “war chest” to enable it to:

• Buy other companies
• Protect itself against a possible catastrophe
• Repurchase its own stock, when prices are low
• Ensure adequate working capital to run the business
Wonder Widget is a relatively new company, so its retained
earnings are still low.
Some companies actually have negative retained earnings,
because they’ve lost more money than they’ve made over their
existence. (This is the situation for most airlines.) You can usu-
ally recognize this by the caption “Deficit in retained earnings.”