Internal Sources of Finance: Retained Profits (2/4)

Internal sources of finance come from within the business. Retained profits belong to internal sources of finance. 

Sources of Finance – Classification

2. Retained Profits

Retained profit is the amount of business’s net income that is kept within its accounts.

Where do retained profits come from?

Once a business has paid all of its costs of production (e.g. raw materials, wages for production workers, packaging, etc.) and all of its other expenses (e.g. rent, salaries for managers, interest on borrowings, TAX, etc.), then the Net Profit remaining belongs to the company and its owners. 

If a company is trading profitably, retained profit is the value of profit that the business keeps after paying Corporate TAXes to the government and dividends to the owners (shareholders). So, retained profit is the profit remaining in the business after all costs, TAXes and dividends have been paid.

The owners of a profitable business may decide to take some of this profit for themselves to fund their fancy lifestyle while reinvesting the rest back into the business. 

Once invested back into the business, these retained earnings will never be paid out to shareholders anymore, so they represent a permanent source of finance. Retained profits will be used within the business for future business activities.

How much of retain profits can the business have?

The amount of retained profits available at the end of the trading year is likely to be higher for a multinational company than it is for a sole trader. 

For large multinational companies, retained earnings are a very significant source of funds for expansion. Also, older companies will have more retained profits because new companies have either none or very little.

Nevertheless, retained profits remain as a very important source of finance for businesses of all sizes and types. 

Example 1: The Super Business Manager website has already started generating its first earnings, mainly from Google Ads placed throughout the website. While the total earnings in 2021 were very small overall, I will use the first few hundred USD$ to reinvest back to grow my online project. The retained earnings will be spent mostly on renewing the domain name www.superbusinessmanager.com for another year, and to pay for more server space. The number of readers has already reached 30,000 amazing people from all around the world at the end of 2021. Based on my rough estimations, we may have here as many as 150,000 readers in 2022. If you find what I do valuable, you can support my project through SPONSORSHIP.

How to calculate retained profits?

The company’s Net Profit After Interest and TAX can be distributed between dividends and retained profits This distribution will be showed in the appropriation account, the part at the bottom of the company’s Profit and Loss Account (P&L Account).  

Let’s say that Company ABC had earned USD$100,000 after paying interest and TAX. This amount belongs to the owners of that company. The Board of Directors decided to pay out 30% of this profit to the shareholders as dividends. 

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So, the remaining 70% of Net Profit After Interest and TAX will be kept in the business as retained profit as the company is planning to open another shop next year. Therefore, the retain profit becomes a source of internal finance which The Board of Directors can use to fund future projects starting from next year. 

What are retained profits used for?

Retained profits are often used for purchasing new Fixed Assets such as land and buildings, or upgrading current Fixed Assets, researching and developing new products, hiring more workers, etc. Some retained profit might also be kept as a contingency fund in case of emergencies, and for unforeseeable expenditures in the future.

Benefits of retained profits

1. Free of charge. The retained profits have been earned through regular business trading activities. So, there is no cost to the business as retained profits do not incur any interest charges.
2. Help to increase the stock price. Retained profits will increase the stock value of public limited companies. Maintaining company net earnings will increase the Balance Sheet which will have a knock-on effect on shareholder equity and the corresponding stock value. 
3. Make the company final accounts look better. Retained profits make the company’s books look better, therefore it is easier to attract new investors. 
4. Provide safety net. Retained profits will provide safety net for the business. Holding excess profits can also increase liquidity. This provides stability for the business and financial safety for any unexpected events.
5. Suitable for driving future business growth. Retained profits give a solid fund for Research and Development (R&D). By regularly reinvesting net earnings back into the company, business managers can drive future growth.

Drawbacks of retained profits

1. Not available to new companies. A newly formed company will not have any retained profits.
2. Not available to loss-making companies. A company trading at a loss will not have access to this source of finance. Retained profits are only available when the business is profitable. If a business makes a loss, then there will be nothing for reinvestment.
3. Only limited amounts might be available. If profits are low, then there will not be enough retained profits to fund large investment projects. 
4. Using loan capital for growth can be more beneficial. An important thing to consider is the cost of borrowing money instead of using retained profits for growth. The interest rates might be low, yet favorable, when borrowing money from a bank rather than relying on the growth rate of existing profits. 
5. Dissatisfaction of shareholders who may prefer dividends instead. Some of the shareholders may not agree to give up their dividends which they are entitled to receive from a profitable business. Some shareholders are more willing to receive higher dividends than to see the reinvestment of funds to increase the stock value in the future.

In many cases, owners will receive part of the Net Profit After Interest and TAX as dividends. And, the rest of net earnings are kept as retained profits and ploughed back into the business. 

However, it is important to point out that many technology companies these days such as Google, Amazon or Meta Platforms do not pay any dividends to their owners (shareholders). Instead, these fast-growing companies reinvest all of their net earnings for future growth to fund new profitable projects and drive continuous business growth. 

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