What is retained profit?

Every company owner wants to build a successful and profitable business. Knowing the difference between various types of profit is important to measure your company’s success. 

This guide will help you answer the question “what is retained profit?” by exploring the following topics:

• The definition of retained profit
• How retained profits work for businesses
• The difference between profits and retained profit
• How net income and dividends affect retained profits
• The retained profit formula

Read on to learn more about retained profits and what they mean for your business. 

Retained profits, also known as retained earnings, are the net income (money you made after subtracting taxes and other deductions) your company makes that you don’t distribute to your shareholders. These profits are retained within your company. 

You can use your retained profits to reinvest in the business, such as through research and development, replacing equipment or paying off debts. 

Your company’s retained profits demonstrate the earnings you have left after fulfilling your payment obligations, such as distributing any dividends (profits you pay out to shareholders) and paying operational expenses. 

As such, retained profits determine whether your company is profitable and has enough funds to invest in itself. Those reinvestments can help boost future profit, for example, by paying off loans. 

Positive retained earnings indicate that your business has more profits than expenses. Negative retained earnings mean that your company has accumulated a deficit and that your debts and expenses exceed your profits. 

Retained earnings or profits cause different pressures for public and private companies. Large public companies typically have many shareholders (people who own shares in the company) to pay dividends to. 

Retained earnings help improve the company’s financial health, but dividends attract investors and keep the business’ stock prices high. Therefore, public companies must strike a balance between profits and dividends.

Small business owners usually have it easier when it comes to retained profits. Investors who buy shares in a new company will likely expect its first few years to focus on growing and expanding the business. 

Therefore, small business owners have less pressure to provide dividend income to investors. Your shareholders know your business is just getting established and will only be pleasantly surprised if you can afford to distribute dividends. 

Simply put, your profit is the company’s net income: your total earnings from selling your products or services. Profits (or net income) are considered the bottom-line for companies. 

A company’s retained profits are held (or retained) as a safety net in case you need extra money in the future. Retained profits are like a long-term savings account for your business, and your profit acts as recurring deposits into that account.

Sole traders do make retained earnings. However, as a sole trader, you don’t need to keep a separate account for your retained profits since you don’t pay out dividends to shareholders. Still, as the company owner, you must keep track of your expenses, revenue, and net income (profits). 

You must also keep a log of how much money you keep in the business to use for equipment, transportation, postage, and other expenses. These are your retained earnings and show up on your balance sheet during your Self Assessment as part of the equity you have in the business. 

How do my net income and dividends affect my retained profit?

Dividends and net income (or profits) affect retained profits in the following ways:

Any changes in your profits (or net income) have a direct impact on your retained earnings. An increase or decrease in net income will pave the way to either profitability or deficit. Net loss (where you make less than you spend) can cause negative retained earnings. 

Additionally, items that affect your net income affect your retained profit, such as sales revenue, stock reductions, or operating expenses. 

Circumstantial changes also affect your net income. For example, if a global pandemic creates lockdown restrictions that force you to close up shop for months on end. Not great for business!

Companies distribute dividends to shareholders either in the form of cash or stock, which can reduce your retained profits. How much you’re obliged to pay out to a shareholder depends on how much of your company they own. 

For example, if a shareholder owns 10% of your company shares, you must pay them 10% of the dividend value. This affects your retained profit value since the more you pay out in dividends, the less retained earnings you have left.

Companies do not pay income taxes on retained earnings/profits. Retained profits are what your company has available to reinvest in itself after paying your bills, dividends, taxes, and other expenses.

Calculating your company’s retained earnings is a lot more straightforward than you might expect. Simply use the formula below:

Current Retained Earnings + Profit (or – Loss) – Dividends = Retained Earnings

Let’s say your company made a total of £5,000 in retained earnings last month. That sum is your current retained earnings. Now, let’s say you made £10,000 in profits this month and had to distribute 60% of that in dividends to your shareholders, which is £6,000. 

£5,000 + £10,000 – £6,000 = £9,000

This means that your company made £9,000 in retained earnings. If you made a £2,000 loss instead of profit, you would subtract that sum from the current earnings:

£5,000  – £2,000 – £6,000 =  –£3,000

As you probably assume, this means your company made a £3,000 negative retained profit this month. 

One month of negative retained earnings is no disaster, especially if you’ve made positive earnings leading up to this month. You just use money out of your retained ‘savings account’ to tide you over until business picks up again!

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