What Happens to External Funds if You Reduce the Payout Ratio? Accounting Tools recommends you do that by making closing entries to your Revenue, Expense and Dividend accounts at the end of the period. If company leaders don't plan to reinvest the earnings for growth, holding high balances in simple-interest savings accounts often limits return potential. If you're making plenty of money, you should have more retained earnings. If your corporation ends the quarter or the year with a profit, that's great news. If you anticipate big losses in the coming year, retaining earnings as a cushion is a smart move. Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. What makes for a good retention ratio depends partly on your company's circumstances. Excessive retained earnings causes dissatisfaction amongst the shareholders as this reduces the amount of the dividend receivable by them. In the first retained earnings example above, net income of $48,000 less $25,000 in dividends equals $23,000. Your net income for the year after deducting all your expenses is $48,000, giving you $198,000 in earnings. Accountant Skills: Retained Earnings: A Flexible Source of Finance, Bench: Statement of Retained Earnings: A Complete Guide, How to Calculate Retained Earnings on a Balance Sheet. This portion of the company’s net profit is often used to reinvest in the business itself. Like so many things in business, retaining earnings can be a good policy or a mistake. If you need outside capital down the road, you may not have developed the relationships with investors and lenders that you need to secure funding. The more earnings you distribute, the less you retain. Advantages & Disadvantages of Retained Earnings. With more shareholders, there may be more pressure down the road to issue large dividends instead of reinvesting earnings. Companies can either issue earnings as dividends or retain them for investment and other spending. If shareholders think you're relying too much on earnings or not using the money effectively, they may feel cheated of their dividend income. It merely separates the figures of the retained earnings equation to show the period's initial retained earnings, the amounts added to or subtracted from that starting point, and the final result. Accounting Tools advises that when investors evaluate your retained earnings policy, they consider several factors: However you decide to spend your earnings, you need to keep track of the spending in your ledgers. ii. Limitations of Retained Earnings As with many financial performance measurements, retained earnings calculations must be taken into context. That's how temporary accounts work. Accountant Skills lists several advantages to using retained earnings as a source of cash for these things: There are possible downsides to relying on retained earnings.