Retained earnings is a balance sheet item included in the equity section; it is the accumulation of all the profits of a company from the point of its commencement minus the profit which has been distributed to the shareholders as dividends.
This is assuming that entity making profits.
However, most companies making losses at the starting point of their business and there is not retained earnings but accumulated losses.
The remaining profit after the distribution is reinvested in the business or is set aside as a reserve for a specific purpose such as the expansion of the business or repayment of debt. It is calculated by the following formula.
|Opening retained earnings||XXX|
|Profit/(Loss) for the year||XXX/(XXX)|
|Closing retained earnings||XXX|
The above movement in the account of retained earnings is also shown in the statement of changes in equity; this statement is also part of the final accounts of a company.
Total assets are the total amount of items of economic value owned by a person or an entity that is used for a probable flow of income.
Retained earnings to total assets is a ratio which helps in measuring the profitability of the assets of an entity.
It illustrates how much profits over all the years since inception were generated from $1 of total assets. This ratio also gives the company an idea of how much it relies on debt for the funding of its total assets.
A business can finance its operations through equity or debt. Debt includes loans which are to be repaid after a certain amount of time usually with an amount of interest whereas in equity a business raises capital by offering its shares to the public in stock exchange or to the private individuals; it can also increase its retained earnings by announcing dividends at a lower rate or by cutting cost and increasing profits.
Funds raised through equity do not require to be paid off later but the stake of the company is relinquished from the owners to more shareholders through shares.
Retained earnings to total assets depict the financial leverage of the entities, it indicates how assets were financed from retention of profit instead of paying profit out as dividends and acquiring loans.
Retained earnings total asset ratio = Retained earnings / Total assets
Below is the calculation of the ratio.
|Non-current assets||Current Liabilities|
|Property, Plant and equipment||470,000||Trade Payables||65,000|
|Current Assets||Non-current liabilities|
|Inventory||45,000||Ordinary share capital||250,000|
|Total Assets||600,000||Total Liabilities and Equities||600,000|
From the above balance sheet retained earnings to the total assets is calculated as follows
Retained earnings total asset ratio = 135,000/600,000
In this case, the ratio ascertains that 22.5% of the total assets used for operations are funded by the retained earnings, the rest of 77.5% are financed by share capital and debts.
It also shows that for every $1 of assets, a $0.225 accumulated profit has occurred. Therefore, it also measures the profitability of the assets.
The higher the ratio the better because it shows that the entity was successful enough to generate high profits and was able to retain the profits to reinvest in the business.
This is one of the types of equity financing and the most prominent advantage of high retained earnings is that the funds are not required to be payback; no monthly payments, interest payments, unlike debt finance which means the business is most likely to have healthy liquidity position and better cash flows.
If the equity section of the balance sheet is less than the liability section and the retained earnings to total assets ratio is quite low as compared to the industry’s ratios; this will show an alarming situation, the company will be seen as highly geared, which means the company relies mostly on debt for financing it activities.
The investors may not prefer this because most of the proportion of the profit will be used to cover the interest payments and fewer profits will be remained for dividends and for retained earnings. Interest payments can become burdensome and can create cash flow problems.
This can also affect the credit score of the company with too many short term liabilities, unable to settle these can also lead to bankruptcy.
There are no ideal retained earnings to total assets ratio for all the entities, usually, a high ratio is desirable but the ideality of the ratio will vary from industry to industry and from newly commenced businesses to well-established companies, for a better comparison industry’s benchmark ratios must be determined and comparisons must be made with the similar business at the same stage.
Following is the illustration is given to differentiate between the retained earnings of unalike industries.
According to the balance sheets as of 2017 of Apple Inc.
Total assets equaled $375,319 and the retained earnings amounted $98,330 (all in millions)
RE/TA = 98,330/375,319
Whereas in the balance sheets as of 2017 of Amazon
Total assets were $131,310 and the retained earnings equaled $8,636 (all in millions)
RE/TA = 8,636/131,310
The calculations show that Apple has more retained earnings and can easily fund internally whereas Amazon will need to acquire debt.
However, both entities are operating in different industries comparing them to measure how successful they are will not give suitable conclusions.
Mostly new startup business has few retained earnings and usually losses in the beginning years, there retained earnings to assets ratio can be too low or negative as well but gradually as the small businesses progress and become profitable the ratio then also goes up.
This shows growth and investors prefer putting their money in these businesses.
However, if any business experiences a downfall in their ratio overtime this will portray that the company is having problems maintaining or increasing its profitability from its operations and it can also mean that it is paying off a lot of dividends to the equity holders reinvesting profits.