DEFINITION: The phrase “retained earnings” (also known as “plow back”) refers to the amount of profit a company has left after paying dividends to shareholders, as well as its income taxes and its direct and indirect costs.
Thus, retained earnings represent the portion of a company’s equity that can be used for investment in new equipment, in marketing, or in research and development.
The term “retained” in the phrase “retained earnings”—a crucial concept in the field of accounting—points to the fact that these earnings have been kept within the company, rather than being distributed to shareholders as dividends.
Hence, when a company either incurs losses or distributes dividends, retained earnings will fall, whereas when new profits are generated, retained earnings will increase.
ETYMOLOGY: The phrase “retained earnings” likely arose sometime in the early twentieth century. It is well attested by 1930.
The English adjective “retained,” from the verb “to retain,” is attested from the fifteenth century. It derives from Middle English reteinen or retainen, which derives from Middle French retenir, with the same meaning. The Middle French verb, in turn, derives from the Latin verb retineo, retinēre, meaning “to hold back,” “to keep,” “to reserve,” or “to maintain.”
The English noun “earnings” is attested from the seventeenth century. It derives from the noun “to earn,” which derives from the Middle English verb ernen and, ultimately, the Old English verb earnian, both with essentially the same meaning.
USAGE: Retained earnings may be defined by the following formula:
RE = PRE (+ NI or – NL) – (C + S)
RE = retained earnings
PRE = previous RE
NI = net income
NL = net loss
C = cash dividends
S = stock dividends
Note that the notion of “retained earnings” encompasses the previous earnings a company has accrued, excluding any dividends disbursed in the past.
To gain a deeper understanding of the insights that the concept of retained earnings may provide, the following choices encompass many of the ways in which a company can use its excess funds. For instance, the first option (dividend payments) results in earnings leaving the company’s financial books permanently.
The remaining options preserve earnings for internal use within the company. It is these investment and financing actions that constitute the company’s retained earnings.
- Generated income may be distributed, in whole or in part, to shareholders through dividend allocations
- Income may be channeled into expanding current business operations, such as hiring additional sales representatives or increasing production capacity
- Income may be invested in the introduction of a new product or product line, such as a refrigerator manufacturer diversifying into air conditioner production or a chocolate cookie manufacturer launching strawberry- or lemon-flavored products
- Income may also be allocated for potential mergers, acquisitions, or partnerships that hold the promise of enhanced business opportunities
- Income may be used to facilitate share buyback initiatives
- Income may be directed toward repaying any outstanding business loans or other debts
In these ways, retained earnings embody reserved funds that a company’s management may reinvest back into the business. When presented as a portion of total earnings, retained earnings are also referred to as the “retention ratio,” which is equivalent to one minus the dividend payout ratio.
While the final option of repaying debt also results in funds exiting the business, it does influence the business’s financial records—such as reducing future interest payments. This option makes the funds eligible to be included in retained earnings.