Retained earnings are the portion of past earnings retained within the business itself. They are an important source of internal finance for businesses looking to finance long-term projects.
For a business to be able to rely on these earnings to fund its activities, it has to have first made profits. As a result, this method could be difficult to use for newly established businesses due to the usually limited profitability in the first stages of production caused by significant initial costs. And even for profitable companies, satisfying this first condition alone is not entirely sufficient as they will need to take into consideration how much of their profits to distribute in the form of dividends to the shareholders before accounting for profits that are retained (if any). The following formula summarises the calculation of retained earnings in a given year:
Retained earningst = retained earningst − 1 + income (loss)t − dividends distributedt
Where t represents the current time.
From the above formula it is evident that retained earnings carry opportunity cost for the company, which has to carefully consider the consequences of deciding not to distribute them to investors. In fact, the higher the dividends distributed to shareholders, the lower the amount of retained earnings and vice versa.
You will now look at the main external sources of financing.