Appropriation of retained earnings

Appropriation of retained earnings
See also
Yield on cost Asset equity ratio Ebitda ratio Dividend Direct paper Investments Types of dividends Ownership interest Net gain

The appropriation of retained earnings shall be understood as is the allotment of the company's net profit which includes a portion retained in order to invest into the further development of the company. The primary function of retained earnings as supplementary capital is to cover possible losses, but it also functions as a kind of support and stabilisation for a company (Irdha Yusra, Rizka Hadya, Rhini Fatmasari, 2019, pp. 216-220).

Definition of retained earnings

The retained earnings are the result of the appropriation of the net profit earned by a company in a given financial year into the portion paid to the owners and the portion that is retained in order to undertake investments for the company's future development. It is the difference between the net profit and the amount of dividends paid. Retained profit informs about the ability of an economic entity for self-financing. It is a component of the equity of a company. It can be distinguished from core capital by the fact that it is disposable, whereas core capital is long-term and static (Georgios Papanastasopoulos, Dimitrios Thomakos, Tao Wang, 2010).

Appropriation of retained earnings

The retained earnings in a company can be divided into the following capital categories:

• supplementary capital – it is obligatory in a joint-stock company, while optional in a limited liability company. If the company has made a profit in a given financial year, it must transfer 8% of the annual net profit until the supplementary capital reaches a third of the core capital. It is qualified as the retained profit.
• reserve capital - it is generated optionally from the company's profit. It is created for various purposes, usually to cover possible future losses or expenditures of the company. It may also include special purpose funds. The fact that this capital is created solely from the company's profit makes it possible to associate this category with retained profit as well.
• current reserves – includes undistributed profits from previous years. The amount of undistributed profit increases the profit from previous years, therefore it is treated as retained profit.

The net profit made by an enterprise in a given year is usually allocated to one of the above-mentioned categories. It is often considered that retained earnings should be identified with the value of undistributed profits, but this is a much wider term. It is because the amounts which have been allocated by the company to the supplementary capital and reserve capital must also be taken into consideration (Georgios Papanastasopoulos, Dimitrios Thomakos, Tao Wang, 2010).

Dividend policy versus retained profit

The amount of retained earnings, i.e. the capital generated from net profit distributions, illustrates the owners' contribution to the growth of the company's capital, thus increasing its income potential. Therefore, retained earnings are primarily used by a company for the purpose of self-financing. In the long term, thanks to the retained earnings company has more prospects for further development. The company's dividend policy is closely connected with the idea of retained profit. The dividend is paid out of the company's net profit and therefore influences how much money remains in the company after the owners’ or general meeting's decision about the appropriation of profits. If owners create large financial reserves in the form of retained earnings, thus paying dividends sporadically, there exists a high risk of weakening the bonds between shareholders and the company. This can, in extreme cases, lead to investors retreating. That is exactly why it is vital to choose the appropriate strategy in the company's divided policy. Dividend payment strategies:

• Fixed dividend policy,
• Fixed dividend payment rate policy,
• Surplus dividend policy,
• Company's target payout ratio (Lintner's model),
• 100% dividend payment rate policy,
• 0% ratio dividend payment rate policy (Irdha Yusra, Rizka Hadya, Rhini Fatmasari, 2019, pp. 216-220).

Examples of Appropriation of retained earnings

• Capital Expenditure: A certain portion of the retained earnings can be allocated for capital expenditure in order to purchase new assets, such as new equipment and machinery, or to upgrade existing assets. This allows a company to increase its production and efficiency and stay competitive in the market.
• Expansion of Business: The management of a company can also use retained earnings to expand its business operations. This involves investing in new products or services, or entering into new markets, which can require a large outlay of cash.
• Purchase of New Shares: Another way to use the retained earnings is to buy back the company's own shares. This is usually done to improve the financial position of the company by reducing the number of shares outstanding, and thus increasing the value of the company's shares.
• Dividend Payments: The board of directors of a company may decide to use some of the retained earnings to pay dividends to shareholders. This is done to reward shareholders for their loyalty and provide them with a return on their investment.
• Research and Development: A company may also choose to use some of its retained earnings for research and development activities. This involves investing in new technologies and products that can help the company to stay ahead of the competition.
• Retention of Earnings for the Future: The last way to appropriate retained earnings is to keep them for the future. Retaining earnings gives the company more financial flexibility and allows it to respond quickly to changing market conditions. This can be particularly beneficial during times of financial difficulty.

Advantages of Appropriation of retained earnings

The appropriation of retained earnings has numerous advantages:

• Firstly, it allows a company to stay afloat during difficult economic times, as the retained earnings act as a financial buffer. The availability of these funds can help a company pay its bills and sustain itself, even when sales are low.
• Secondly, retained earnings can be used to finance new projects and other investments, without the need to take on additional debt. This allows a company to maintain its current debt levels, while still taking advantage of the new opportunities available to them.
• Thirdly, the use of retained earnings can help a company to remain competitive. By reinvesting the profits back into the business, a company can stay ahead of the competition and increase its market share.
• Lastly, retained earnings can also be used to reward shareholders for their continued support. This can take the form of dividend payments or share buybacks, which can boost shareholder confidence in the company and increase their willingness to invest.

Limitations of Appropriation of retained earnings

The appropriation of retained earnings has certain limitations which may affect the financial health of the company:

• Lack of flexibility: Once the retained earnings are allocated to a certain purpose, they cannot be easily re-allocated. This lack of flexibility can cause problems in the event of an unforeseen change in the company's financial situation.
• Possibility of misallocation: Appropriation of retained earnings could potentially be misallocated if it is not managed and monitored carefully. This could lead to inefficient use of funds, which may lead to financial losses for the company.
• Loss of potential return on investment: The retained earnings are usually invested in long-term projects or assets, which may not generate the expected return on investment. This could lead to a loss of potential profits for the company.
• Potential for overinvestment: If the retained earnings are not spent wisely, the company may end up overinvesting in certain projects and not getting the expected returns. This could lead to potential losses for the company.

Other approaches related to Appropriation of retained earnings

• Reinvestment of Retained Earnings: Companies may reinvest retained earnings in the business in order to fund new projects or expand existing ones. This is generally considered to be a good use of the money.
• Pay Dividends: Dividends are distributions of a company's profits to shareholders and are usually paid out of retained earnings.
• Pay Off Debt: Companies may use their retained earnings to pay off debt. This can help to improve the company's balance sheet and, in turn, its credit rating.
• Repurchase Stock: Companies may use their retained earnings to repurchase their own stock. This can help to increase the stock price and benefit shareholders.
• Acquisitions: Companies may use their retained earnings to finance acquisitions of other companies. This can be a strategic move for the company to expand its operations.

In conclusion, companies may use their retained earnings for various purposes, such as reinvestment, dividends, debt repayment, stock repurchase, and acquisitions. The choice of which approach to use depends on the company’s specific needs and goals.

References

• Khan SH., (2009), Determinants of share price movements in Bangladesh: Dividends and retained earnings, "Blekinge Institute of Technology"
• Papanastasopoulos G., Thomakos D., Wang T., (2010), The implications of retained and distributed earnings for future profitability and stock returns, "Review of Accounting and Finance"
• Yusra I., Hadya R., Fatmasari R., (2019), The Effect of Retained Earnings on Dividend Policy from the Perspective of Life Cycle, "1st International Conference on Life, Innovation, Change, and Knowledge"

Author: Sylwia Pasternak