Retained Profit in Business: The advantages and disadvantages
The meaning of retained profit, how it benefits businesses and the formula to calculate it.
Globalisation has made us more interconnected, but it has also brought greater complexity.
Volatility and uncertainty. Political strife. Global health crises. Technological disruption. Companies face more challenges than ever.
Despite the uncertainty, small and large companies have been able to generate profit. This accumulation of profit is called retained profit.
This article at a glance
Depending on the company’s financial goals, companies can choose how to allocate the money for their businesses once there is retained profit. Certain decisions made by a company will have a significant impact on business. Thus, it is crucial to understand what retained profit can do for a business on the road to growth. This article will share the advantages and disadvantages of retained profit in business and the formula to calculate it.
What is retained profit?
Retained profit is a net profit that you have accumulated over the years of your business operation, after taking account of your shareholder’s dividends. In simpler terms, it can also be viewed as ‘leftover income'. The word ‘retained' shows that the earnings are being kept and not used for paying dividends to the shareholders.
How do retained profits work?
Annually, your financial statement will determine whether your business has made a profit or loss. As your business grows, your profits will also accumulate. After taking account of the shareholder’s dividend payout with the cumulative net profit, you will get your retained profit. The idea of retained profit is to determine if you have sufficient funds to reinvest in your company or pay off any outstanding debts.
Retained profit reflects your company’s financial stability. It also presents reliability to potential investors or international partners if you are looking for future business partnerships.
Understanding retained profit and what it means for your business
Retained profit gives you an overview of your business’s health. Once you know your retained profit, you can think about what you want to do with the funds. It’s an important decision for a business leader to make, as every decision will significantly impact your business.
Depending on your company’s financial goals, here are some options you may want to consider:
- Distribute the profit as dividends to your shareholders
- Use the profit to reinvest in your company, such as getting new computers, equipment or computer software
How does a retained profit affect different business sizes?
Profits and losses affect companies of all sizes. Similarly, retained profit will affect your company depending on its business structure.
Large public companies typically comprise a group of shareholders. Due to the lucrative nature of such businesses, large public companies tend to attract monetary investment from investors. As such, they may strike a balance between keeping the money for investment in the company or divvying it out to shareholders.
Small businesses don’t experience this issue. Investors who usually invest in small companies don’t expect to be paid in dividends — they usually understand that a small business requires time to grow.
Whereas, companies with no shareholders must keep track of their expenses, revenue and net income even though they don’t have to pay dividends.
Advantages of retained profit
Retained profit has its advantages. Here’s why:
- External funding — With retained profit, you don’t have to get a bank loan to finance your business. Besides, the application process for loans can be tedious.
- Boost confidence — Potential investors or partners are interested in a company’s profitability. If your company shows a positive retained profit, potential partners won’t hesitate to work with you as your company has a proven track record.
- Financial safety net — Global issues affect the economy in many ways. Markets collapse overnight, which leads to fluctuating prices. With such uncertainties, your retained profit serves as a reserve to keep you afloat during challenging times.
Disadvantages of retained profit
With every rise comes a fall. In the same way, retained profit also has disadvantages.
- Losing an advantageous interest rate — Using your retained profit to finance your company’s needs isn’t always efficient. If your bank’s interest rate is less than the percentage of your company’s retained profit, borrowing money from the bank will sometimes be more efficient than relying on your retained earnings.
- Dividends to shareholders — You may use the retained profit to reinvest in your company. However, shareholders may prefer receiving cash dividends to reinvesting in the company.
How much profit should a company retain?
How long is a piece of string? It varies between companies.
Some companies may view shareholders as their number one priority, so will pay dividends over reinvesting in the company.
However, other companies use retained profits to expand their business operations.
Ultimately, it boils down to the company’s short and long-term goals.
How to calculate retained profit: the formula
To calculate, you need to prepare the following figures:
Opening retained profit
This amount refers to the net profits left over from the previous accounting period as you bring it forward to the next.
This figure is calculated after you have considered your operational cost and taxes.
This is the amount you have distributed to your shareholders.
Halo Acorn Ltd earned £6000 in retained profit in the previous accounting period.
After calculating operational costs and taxes, they made £300,000 at the end of 2021. They decided to distribute £5000 as dividends in cash to the shareholders.
Opening retained profit + net income — dividends = retained profit
£6000 + £300,000 — £5,000 = £301,000
Retained Profit FAQs
We have explained the essential part of a retained profit. Let’s delve a little deeper.
Where is retained profit on a balance sheet?
Retained profit is a type of equity that can be found in the equity section of a balance sheet. It measures all profits a business has earned since its inception.
What is the difference between retained earnings and retained profit?
Retained profit is also known as retained earnings. In other words, there’s no difference between them and they usually appear on the balance sheet.
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