The advantages and disadvantages of retained profit
Making and selling products and services is just the start of running a successful business. Once the money starts coming in, you need to decide how to allocate revenue. If the business is publicly owned, do you pay out dividends to your shareholders, or do you keep the money in the business?
This decision can have a significant effect on the long-term success and financial health of your business, and there are several factors to consider before making a decision. 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 (after tax), 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 which potential investors will pay attention to.
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 accruing 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 invest in building and improving the business. The idea is that everyone (including shareholders) will benefit from increased profits in the long run.
Create a safety net
Every business experiences ups and downs, so it’s crucial to have a plan in case of a sudden downturn. If a certain initiative turns out to be unprofitable, 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 and interest.
Boost investor confidence
Having more money in the company purse 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 short and long-term goals. What’s the risk appetite?
These are the types of questions founders and CEOs should be asking themselves when making decisions about retained profits versus shareholder dividends.
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The amount of profit a company retains is affected not only by shareholder considerations, but by how much revenue is coming in and what costs are going out.
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Tilly manages the content strategy for Airwallex. She specialises in content that supports businesses in their growth trajectory.
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