Definition:

Retained Earnings refer to the portion of a company's net income that is retained by the company rather than distributed to its shareholders as dividends. It is used for reinvestment in the business, paying off debt, or saving for future use.

Examples

1. A tech company earns a net income of $1 million and decides to retain $700,000 for research and development while distributing $300,000 as dividends.
2. A manufacturing firm retains all of its $500,000 net income to fund the expansion of its production facilities.

Formula:

Retained Earnings = Beginning Retained Earnings + Net Income - Dividends Paid

How to use the metric:

Retained Earnings can be used to assess a company's financial health and its ability to reinvest in growth opportunities. It indicates how much profit is being reinvested in the business versus being paid out to shareholders.

Limitations:

Retained Earnings do not provide insight into how effectively the retained funds are being used. A high retained earnings balance might indicate a lack of profitable investment opportunities or inefficient capital allocation.

Applies to:

Retained Earnings are applicable across most industries, particularly those that require significant reinvestment for growth, such as technology, manufacturing, and pharmaceuticals.

Doesn't apply to:

Retained Earnings may not be as relevant for industries with high dividend payout ratios or those that operate with a business model focused on distributing most of their profits, such as Real Estate Investment Trusts (REITs) or certain utility companies.

Summary:

Retained Earnings represent the cumulative amount of net income that a company retains for reinvestment or debt repayment. While it is a useful metric for understanding a company's reinvestment strategy, it does not provide information on the efficiency of capital allocation. It is applicable to most industries but may be less relevant for those with high dividend payout models.