Importance of a Retained Earnings Statement
A statement of retained earnings indicates the total owners' equity in the business at a specific period in time. The owners' equity is simply calculated by subtracting the firm's total assets from its total liabilities. This basic financial statement is important to a variety of stakeholders, including the shareholders, the board of directors, potential investors and creditors.
The retained earnings statement is important to shareholders because it indicates how much equity they collectively hold in the company. The retained earnings are, essentially, the total amount of money that shareholders are entitled to -- though they can only receive the money when a dividend is paid out at the discretion of the board of directors. By dividing the retained earnings by the number of outstanding shares, shareholders can calculate how much money one share entitles them to.
The retained earnings statement tells the board of directors how much money they have to either invest in the firm or redistribute to shareholders. The board of directors is responsible to shareholders and must ultimately make a decision in their interest. They may either use the money to invest further in the firm or they can convert the retained earnings into a dividend that is paid out to shareholders.
Potential investors will look carefully at the retained earnings statements for the firms that they are considering investing in. They will look not only at the most recent retained earnings statement but at statements over time. This can give investors a sense of how much money they can reasonably expect to earn from their investments.
Creditors will look at a variety of performance measures, including retained earnings, before issuing credit to a business. High retained earnings indicate that the firm is profitable and should have few problems repaying its debts. Low or nil retained earnings indicate that the firm may have problems repaying its loans; creditors may, therefore, choose not to extend credit to these businesses or they may charge a higher rate of interest to compensate for the risk.