One of the signs of a successful corporation is ever increasing retained earnings. So, what are retained earnings? Retained earnings are the part of a company’s total income that is not spent to pay salaries, service debt, pay rent, or pay other costs of operation. What are retained earnings? They are a measure of how much money a company makes and how efficiently it is being run. Thus we want to see lots of retained earnings, right? This depends upon a number of factors relating to just what are retained earnings as seen from a number of viewpoints. When one looks for what is a good investment, one looks for a good return on investment. One views anything that reduces return on investment as a problem. The problem with retained earnings is that they are eventually taxed and may be taxed twice or even three times on their way to the shareholder. Thus many profitable companies end up buying out competitors, buying back stock, and even getting into businesses of which they know little in order to avoid excessive taxation of their retained earnings.
Dividend stocks can be very attractive. The investor receives a check every quarter and, in the case of profitable companies, the size of that check may increase every year or so. But, what are retained earnings as regards a dividend stock. The dividends come from retained earnings. When the company pays dividends it also pays taxes on the retained earnings used to pay dividends. The current corporate tax rate is as high as 38%. This is taken from the retained earnings before dividends are paid. Then the shareholder pays taxes on his dividends as well. By the time retained earnings get to the shareholder they are always taxed twice. When the company allows retained earnings to accumulate it may also be subject to another tax. So, what are retained earnings for the tax collector? They are an absolute boon.
If a corporation allows its retained earnings to get above a quarter million dollars the company may be subject to a 15% retained earnings tax. Add this to the tax on dividends paid and the tax that the share holder pays for collecting dividends and one can see why many companies structure their business operation to avoid accumulating cash. They will typically finance operations with loans and then use earnings to pay off their loans. The interest on a loan is a business expense and will, thus, be deductable from corporate taxes. This is bind that successful companies can get into and food for thought for the smart investor. How does a company address the matter of retained earnings and do they do so cost effectively? Many investors prefer companies that use their earnings to further R&D, buy competitors, and generally expand operations. The company becomes more valuable over time and its stock price goes up. When the shareholder sells stock he will pay long term capital gains on the value of the company as seen in its stock. In learning how to invest one considers return on investment. What are retained earnings from the viewpoint of the long term investor? They are on one hand a sign of a profitable company. They are, on the other hand, evidence of poor management and a possibly diminished return on investment.