Retained earnings are the accumulated earnings from a business that it holds onto over time rather than paying in dividends to shareholders or owners. Typically, a relatively high balance in retained earnings correlates with a strategy of reinvesting earnings in growth, at least for the short term.
A proactive benefit of retained earnings is the ability to reinvest in business growth. Company leaders may have plans to expand the business through new buildings or format development, to add new products or services or to invest in more marketing and promotion. In essence, retained earnings are intended to multiply the profitability of business to generate greater earnings down the road. This is common in young companies in the growth stage.
Safety and Flexibility
A more conservative benefit of retained earnings is that they provide a safety net against dramatic financial problems. Some businesses are cyclical or impacted by changing economic conditions. A high retained earnings balance may help prevent inability to cover expenses or make debt payments if cash flow is tight in a given period. Having high retained earnings also helps if a company wants to get new loans.
Limited Return Potential
Retained earnings are usually held in some sort of business savings accounts. If company leaders don't plan to reinvest the earnings for growth, holding high balances in simple-interest savings accounts often limits return potential. Without any foreseeable intent to use the earnings for business growth and development, it might make more financial sense to distribute some amount of the earnings in dividends to shareholders for their use.
Shareholders or company owners are affected by a company's dividend policy. In owner-operated businesses, the owner has greater control over the financial decision regarding whether to retain high earnings balances, or lower that balance by distributing some of it as dividends. In non-owner-operated businesses, shareholders may become frustrated and critical when they notice high retained earnings balances. This is especially true if company leaders haven't communicated an intent to reinvest in growth. In early 2013, activist investors criticized Apple for its remarkably high level of retained earnings and comparatively low dividend payouts.
Neil Kokemuller has been an active business, finance and education writer and content media website developer since 2007. He has been a college marketing professor since 2004. Kokemuller has additional professional experience in marketing, retail and small business. He holds a Master of Business Administration from Iowa State University.