The advantages and disadvantages of retained profit
Creating and selling products and services is just one part of running a successful business. Once the money starts flowing in, you need to decide how to allocate your revenue. If the business is publicly owned, do you pay out dividends, or do you keep the money in the business?
This decision can have a big impact on the long-term success of your business, and there are several factors to consider before making up your mind. First, it’s important to understand the core terminology.
What is retained profit?
Also known as ‘retained earnings,’ ‘trading profits,’ or ‘earnings surplus,’ this is money held in the business, rather than paid out to shareholders. It’s a form of equity that is an important measure of a company’s financial stability, and one in which potential investors will be interested.
It’s also a term that’s crucial to the field of accounting. On financial statements, a company can ‘bring forward’ its retained profit from one period to the next, with the money accumulating over time.
What are the advantages of retained profit?
Invest in expansion
A company that’s focused on growth may pay low or no dividends, because it makes more sense to finance expansion activities. The idea is that more money can be made for everyone (including shareholders) in the long run.
Create a safety net
There are ups and downs in any business, and it’s important to have a plan for a sudden downturn. If a certain initiative turns out to be less profitable than hoped or an unexpected expense arises, it may be possible to borrow money, but this can come with limits and costs. Having money in the bank provides security and doesn’t come with lenders’ fees.
Boost investor confidence
More money in the company’s coffers makes the business look like a more attractive prospect to potential investors. The balance sheet’s bigger; there’s more stability. This can raise the share price, and attract investment, which could create a virtuous cycle of growth.
What are the disadvantages of retained profit?
Early-stage companies may want to keep things simple, and only spend the money they already have. But for some businesses, borrowing might make more sense than retained profit. The average annualised return for the S&P 500 is more than 10%, so if your company can borrow at 5%, it could be a calculated risk worth taking.
Look at Apple: its annual retained earnings in 2021 were $5.6B. In 2013, the figure was $116.6B. However, its stock price and market capitalisation has grown during that time.
Some shareholders may see the wisdom in a company reinvesting money and potentially boosting stock prices, leading to long-term growth. Others may be after shorter-term wins, and become disgruntled if they don’t receive regular payouts.
Potential investors will be aware of the dividend stream, too, and it will affect their opinion of the company accordingly.
How much profit should a company retain?
The answer to this question depends on everything that makes that business unique. What financial obligations does the company have? What are the goals, and are they long-term or short-term? What’s the appetite for risk?
These are the types of questions company leaders should be asking themselves when making decisions about retained profits versus shareholder dividends.
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Tilly manages the content strategy for Airwallex. She specialises in content that supports businesses in their growth trajectory.