Retained Profit Advantages & Disadvantages

0
165
retained profit advantages & disadvantages

If you’re responsible for running a company, and you’re still getting to grips with the complexities of company law and accounting, the following article will provide invaluable insight into the practice of retaining profits and how this can benefit your business.

There are both benefits and drawbacks to retaining profit, but by understanding the pros and cons, this will help you to make an informed decision when it comes to dealing with residual revenue — and the tactical decision to either retain or extract any cash from the business.

 

What is retained profit?

Retained profit is the portion of net earnings made from profitable trading that’s held back by a business. For example, if a retailer buys £50,000 worth of stock, and subsequently sells this stock for £150,000, there will be a £100,000 cash profit. Once corporation tax has been applied to this profit, some or all of this sum can be distributed to shareholders by way of dividends, with any remaining sum being commonly referred to as ‘retained profit’.

Essentially, any earnings kept on the company’s books after tax and dividends are paid out falls within the definition of retained profit. Also referred to as retained earnings, earnings surplus or trading profits, this is money that’s retained in the business, rather than paid out to shareholders. It’s a company’s post-tax/post-dividends profit, although in some instances a decision may be made not to make any dividend payments at the end of an accounting period. This is because, when it comes to net profit in a private limited company, you have options.

You can choose to pay out all of your net profit to shareholders. Alternatively, you can reinvest or otherwise retain this profit, or distribute some and retain the remainder. As profit can be accumulated over many years in a limited company, you don’t necessarily have to distribute profits as dividends straight away. Instead the profits can be kept back in the business and either reinvested or made available for distribution at some point in the future. But why would a business choose to hold on to a percentage of its’ profits? And does this have any downside?

Below we examine the various advantages and disadvantages of retaining profits in a limited company. In this way you can assess for yourself, in the context of your own business, whether retained profits are the best way forward for you and your shareholders.

 

What are the advantages of retained profit?

There are several advantages to retained profit in a business, not least that this represents a key source of low-cost, long-term flexible finance, where management have complete control over how best to utilise this cash flow. Profit made and retained within a business is an ideal way to help finance the running of that business, without the need for external investment or funding. It can cover daily operating costs, such as buying stock and paying staff wages, or help to reduce any overdrafts or loans taken out against the business.

Retained profit can also be used to drive growth. This could include investment in things like new premises and equipment, to recruit more staff, or to fund research and development, all without incurring any additional liabilities. Essentially, undistributed profits held by the business, instead of being immediately paid out to shareholders, can be brought forward for multiple years to amass funding for reinvestment with a view to expansion.

Even if retained profits are not to be used for operational costs or to further growth, but rather retained as a cash balance, this can help to increase the value of the company on paper, making it a much more attractive prospect for further investment. When net earnings are retained, they add to the corporate balance sheet which increases shareholder equity. Increases of this kind provide share price momentum which, in turn, attracts investors and can drive share prices even higher. Had the profit instead been distributed entirely to the shareholders, they would benefit from the dividend, but the value of the company itself wouldn’t increase. Retained profit is essentially a form of equity that’s often seen by investors as a strong indicator of the long-term financial stability of a company.

Finally, by holding back some of the company’s net profits each year, rather than extracting it all at once, this can provide a much-needed financial safety net. There can be ups and downs in any business, so it’s important to have a back-up plan for any sudden economic downturn. If the market takes a turn for the worse or an unexpected expense arises, it may be possible to borrow money, but this can come with both restrictions and costs.

Having access to money in the bank provides security and doesn’t come with lenders’ fees. It also means that the company can continue to provide shareholders with a financial return, even during economically difficult times. This is especially important if your company has a known track record of making regular dividend payments, where consistent payouts is an aspect investors will look for to assess the strength of a company.

 

What are the disadvantages of retained profit?

While on the face of it, retained profit seems like a good way to save money for reinvestment purposes or a rainy day, and to increase the value of your company or strengthen its balance sheet, it’s not always the most efficient option. This is because retained profit, although a low-cost way of financing or providing back-up funding for a business, isn’t entirely free.

There’s actually a very real cost associated with retained profit. This is the opportunity cost for shareholders of leaving profits in the business, instead of receiving a return on their investment and being free to reinvest these sums elsewhere. If retained profits don’t result in higher profits, inevitably there’s an argument that shareholders could make better returns by having the cash for themselves, along with the freedom to decide what to do with their share.

There are also other disadvantages to using retained profits as a source of finance, including the fact that directors can easily face criticism from company shareholders for unnecessarily hoarding too much cash in the business. Even when this cash is reinvested and put to good use, retaining profit isn’t always the most popular option among shareholders, where any decision to hold back some or all of a company’s profits can leave shareholders feeling disgruntled. This can be the case, regardless of any reinvestment plans that could benefit them further down the line. This is because shareholders often prefer to receive higher dividends rather than see the money reinvested to expand the business or to increase share value.

In some ways, ironically, any decision to retain profit rather than extract it from the business can also make your company less attractive to investors, depending on their investment habits. One of the most important considerations for many investors when buying shares is the company’s dividend stream. When profits are retained rather than distributed, even a highly profitable business may be less attractive to investors than would an otherwise similarly profitable company that distributes dividends generously to shareholders.

Finally, depending on the cost of borrowing, interest rates might be more advantageous for your business when borrowing money rather than relying on growth rates of existing profit.

 

How can retained profit advantages and disadvantages be balanced?

Creating and selling products and services is just one aspect of running a successful business. Once the money starts to flow, you’ll need to decide how to allocate your revenue. Do you pay out dividends or do you hold back some or all of this money by way of retained profit?

The concept of retained profit is, of itself, relatively straightforward. However, assessing retained profit advantages and disadvantages is a little more involved, where much will depend on the circumstances of your business. This could include, for example, how much revenue is coming in and what costs are going out, the short and long-term goals for the business, as well as shareholder considerations.

If you’re the only director and shareholder of your limited company, your approach will be different again. In fact, there’s an important and often overlooked tax advantage to retained profit in this context, ie; the ability to retain cash in a company tax-free. In this way, you can avoid liability for personal tax, or a higher rate of tax, on any dividends that you pay yourself.

In some cases, therefore, retained profit can be clearly advantageous, while in others, it may be seen as an inefficient use of capital or cash hoarding. Still, the drawbacks of profit retention aren’t always quite so obvious. By summarising the pros and cons, this can help you to balance the retained profit advantages and disadvantages for you and your business as a whole.

The advantages of retained profit can be summarised as:

  • An important and potentially substantial source of finance for any profitable business
  • Lost cost internal funding for operational costs and/or growth
  • Flexibility and control over how this money is used
  • The ability to boost the value of a company or strengthen its’ balance sheet
  • The ability to attract further investment
  • A financial safety net for emergencies or any economic downturn.

In contrast, the disadvantages of retained profit can be summarised as:

  • The opportunity cost for shareholders
  • The likelihood of shareholder dissatisfaction
  • The possibility of deterring potential investors

 

When is retained profit the right approach for a business?

Ultimately, the question as to the amount of profit a company should retain will depend on a number of different questions that will need to be asked by the company directors when making decisions about retained profits versus shareholder dividends.

A company that’s focused on growth may pay only low or no dividends, because it makes more sense to finance expansion activities. The idea here is that more money can be made for everyone, including shareholders, in the long run. For example, small companies and startups are much more likely not to issue dividends to shareholders, because smaller businesses will not usually have enough leftover cash after reinvesting their profits for company growth.

However, there’s no right or wrong answer when it comes to what you do with net profits. The best course of action will usually depend on your financial obligations and future goals, where retaining profit may not necessarily be the way to go. However, by understanding how retained profit can benefit a business, and by seeking expert advice where needed, this can help to ensure the future success of your business and the approval of any other shareholders.

If you’re new to running a business, or otherwise in need of expert guidance relating to limited companies, a professional advisor can also provide you with advice and assistance on all aspects of accounting for companies. In many cases, it’s better not to learn by your own mistakes, but to seek the help needed to safely navigate the complexities of company law and company tax — leaving you to start earning a healthy profit.

 

Retain profit FAQs

What is meant by retained profit?

Retained profit is the net profit earned from profitable trading after corporation tax has been applied to that profit. Where that profit is kept in the business, rather than being paid out as dividends, this is known as ‘retained profit’.

What is retained profit an example of?

Retained profit is an example one of the key forms of finance for a business. Apart from the opportunity cost to shareholders by way of dividends, this is a low cost, highly flexible and potentially substantial form of internal finance.

What is retained profit on balance sheet?

Retained profit on the balance sheet of a business is the net profit, after tax has been deducted and any dividends have been paid out to shareholders. The total value of retained profits can be seen in the ‘equity’ section.

What is the difference between retained earnings and retained profit?

Retained earnings and retained profit are common phrases that are often used interchangeably to refer to the portion of net earnings made from profitable trading held back by a business for reinvestment purposes or to strengthen its balance sheet.

 

Legal disclaimer

The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal or financial advice, nor is it a complete or authoritative statement of the law and should not be treated as such.

Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission.

Before acting on any of the information contained herein, expert legal or other advice should be sought.