Retained earnings can be used to reinvest in a company and create a greater profit. Here we look at how these savings can be used and when to withdraw them. When a company is making a profit there are two options that the management can act on. The money either needs to be retained within the company balance sheets to be reinvested, or alternatively it can be distributed amongst shareholders as dividends.
When firms and their Sydney accountant decide to retain funds these will need to be integrated into the balance sheets and determined as shareholder equity. This determination of funds actively allows you to analyse the level of investment that is being made by the management over the years in relation to the returns that they are offering to shareholders. If this figure is merely increasing by the same amount each year then the business’ progression and expansion is markedly lacking.
In other words, if the company in question is putting all of its profit back into itself without experiencing any particularly impressive growth, the company would be better placed supplying a dividend to its shareholders.
How Retained Earnings Can Generate Profit
A company should be aiming to increase profit by one dollar for every one dollar which is retained within the company. There are many ways in which a business can achieve this. Through diversification of incomes, investment and company development.
A company can invest in itself to produce a greater profit. This can be achieved through greater spending on marketing, the training of staff, and the purchase of equipment to increase efficiency. An investment in web design, for example, could be expected to increase customer traffic and retention. As long as the customer support and service remains in line with this increase of traffic, the monthly and annual income can be expected to increase dramatically.
Diversification of Incomes
The diversification of incomes is a very important element of business. If you rely heavily on one company or customer to generate the majority of your income then you are in a very risky position. Diversification can come through the means of expanding to a wider customer base or through expanding the range of services that you provide to those customers. Expanding from cough medicine supply to the supply of a wider range of pharmaceuticals, for example, would enable you to attain larger profits from customers each month.
The allocation of retained profits does not have to take place within the company to generate a profit. It is possible to diversify income through the means of investment too. By investing in real estate, for example, it is possible to increase profits from an alternative source. Real estate, stocks and the establishment of daughter companies are common investments for companies to make with their retained earnings.
Real Retained Earnings Example
Microsoft has retained almost $19 billion over the years that it has been trading. It now has over double this amount in shareholder equity and it earned over 12% on this equity in the last year alone. The company is thus clearly using the shareholder’s money very effectively and it would be unwise to withdraw all of these funds as a dividend no matter how attractive the prospect would be.
If you are unsure about the position of your business and how to use your retained earnings to maximise their potential then it’s a good idea to discuss it with your accountant before making any final decisions.