What Are Retained Earnings?

Retained earnings represent the cumulative net profit a company has kept in the business since incorporation, after deducting all dividends paid to shareholders. They appear on the balance sheet under capital and reserves (often labelled “profit and loss account reserve”) and are the primary source of distributable reserves from which dividends can legally be paid.

In the accounting equation, retained earnings form part of equity:

Assets = Liabilities + Share Capital + Retained Earnings + Other Reserves

How Retained Earnings Are Calculated

Retained Earnings = Opening Retained Earnings + Net Profit for the Year - Dividends Paid

Worked Example

This closing figure carries forward as the opening balance for the next accounting period.

Retained Earnings on the Balance Sheet

Under the Companies Act 2006 balance sheet formats, retained earnings appear within capital and reserves:

The “profit and loss account” heading on the balance sheet is the Companies Act term for retained earnings. Under FRS 102, this is disclosed in the statement of changes in equity, which reconciles the opening and closing balance of each equity component.

Retained Earnings and Distributable Reserves

The Companies Act 2006 (sections 830-831) restricts dividend payments to accumulated realised profits less accumulated realised losses. Retained earnings are the main distributable reserve.

Directors must confirm that sufficient distributable reserves exist before declaring any dividend. Paying a dividend from non-distributable reserves is unlawful and directors may be personally liable.

When Retained Earnings Are Negative

If accumulated losses exceed accumulated profits, retained earnings become negative. This means the company has no distributable reserves and cannot pay dividends until it returns to profitability and eliminates the deficit.

Persistent negative retained earnings may also trigger the Companies Act section 656 requirement: if net assets fall below half the called-up share capital, directors must convene a general meeting to consider what steps should be taken.

Journal Entries for Retained Earnings

Transferring Net Profit to Retained Earnings

At the end of the accounting period:

Declaring a Dividend

Paying the Dividend

Factors That Affect Retained Earnings

Retained Earnings Versus Other Equity Reserves

Using Retained Earnings for Growth

Rather than distributing all profits as dividends, companies retain earnings to:

• Fund capital expenditure – purchasing fixed assets without borrowing
• Build working capital – supporting growth in accounts receivable, stock, and current assets
• Reduce debt – repaying loans to lower interest costs and improve gearing
• Provide a buffer – absorbing future losses or unexpected costs without breaching banking covenants
• Finance acquisitions – buying other businesses from internal resources

The retention ratio measures the proportion of net profit retained:

Retention Ratio = (Net Profit - Dividends) / Net Profit x 100

If a company earns £85,000 and pays £30,000 in dividends:

Retention Ratio = (85,000 - 30,000) / 85,000 x 100 = 64.7%

The complement is the payout ratio (35.3%), which shows the share of profits distributed.

Retained Earnings and Financial Analysis

Return on Equity

Return on equity (ROE) measures how effectively the company uses shareholders’ funds, including retained earnings:

ROE = Net Profit / Average Total Equity x 100

A company that retains profits but fails to generate a good return on the growing equity base is destroying shareholder value.

Sustainable Growth Rate

The sustainable growth rate estimates how fast a company can grow using only retained earnings (no new share issues or additional debt):

Sustainable Growth Rate = ROE x Retention Ratio

If ROE is 15% and the retention ratio is 65%:

Sustainable Growth Rate = 15% x 65% = 9.75%

Retained Earnings and Corporation Tax

Retained earnings themselves are not subject to additional tax. Corporation tax has already been charged on the profits before they reach retained earnings. However:

• Dividends paid from retained earnings are not tax-deductible for the company
• Shareholders receiving dividends may pay income tax depending on their personal tax position
• Close company rules (Companies Act) may require a company to justify excessive accumulation of profits if HMRC suspects profits are being retained to avoid higher-rate income tax on dividends

Statement of Changes in Equity

Under FRS 102, the statement of changes in equity provides a full reconciliation:

This statement must be presented as part of the annual financial statements for all companies reporting under FRS 102.

Retained Earnings in Different Business Structures

Limited Companies

Retained earnings are reported as the profit and loss account reserve within capital and reserves. The Companies Act governs distributions.

LLPs

In a limited liability partnership, the equivalent of retained earnings is the members’ undrawn profits held in the partnership. Profit allocation follows the LLP agreement rather than the Companies Act distribution rules.

Sole Traders

A sole trader’s equivalent is the capital account balance, comprising initial capital plus accumulated profits minus drawings. There is no statutory restriction on withdrawals.

Practical Management of Retained Earnings

Dividend Policy

Directors should establish a clear dividend policy that balances shareholder returns with reinvestment needs:

Monitoring Adequacy

Retained earnings should be reviewed alongside the company’s:

• Cash position – retained earnings do not guarantee cash availability (see cash flow statement)
• Investment plans – capital expenditure budgets may require retaining a higher proportion
• Banking covenants – loan agreements may specify minimum equity levels
• Working capital requirements – growing businesses need increasing current assets