Retained profit is a crucial part of any trade. If you’re thinking to set up a profitable business and looking for a significant source of finances, then you need retained profit. Without it, numerous companies might have to borrow a huge amount of cash from banks, or they need to struggle to get a loan in the market. In this blog. you’ll be able to understand what is retained profit, how it is calculated, and what are its advantages and disadvantages?
What is Retained Profit?
As the title suggests, it is the part of the profit held by the company once all other dividends have been distributed to the business owners or shareholders.
Usually, this profit can be kept within the bank; some could be used for the purchases of fixed assets; some are reinvested in more inventories or utilised to minimise loans or overdrafts.
Retained Profit Brought Forward
Retained profit brought forward is the collection of the retained earning from each accounting period since the starting of a business.
A business is in its third year has a retained profit of £5000 in each of the first two years then the amount of retained profit brought forward would be £10,000.
Retained Profit Formula
At the end of every accounting period, retained profit is calculated. This calculation can either be on a monthly, quarterly, or yearly premise.
Retained Profit= Retained profit brought forward + Net income – Drawing/Dividends
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Why Retained Profit is Important?
Income statements and balance sheets are recorded under shareholders’ equity so that is why retained profit connects both. There are several reasons for retaining these earnings such that for spending on research and development, for purchasing new machinery and equipment, and for planning other profit-generating activities.
Advantages of Retained Profit
Following are the major advantages of retained profit.
- They are exceptionally flexible – the administration has full control over how they can be reinvested and what portion should be saved rather than paid as profits.
- They are cheap (in spite of the fact that not free) – The cost of capital of retained profits is the opportunity cost for the shareholders to leave profits in the business (like they could get a return by leaving it in the business).
- They don’t weaken the proprietorship of a company.
Disadvantages of Retained Profit
Following are the major disadvantages of retained profit.
- The danger of storing too much amount of money- Executives of cited companies sometimes get roasted for limiting the value of profits and for storing too much amount of money within the trade.
- Higher affording charges- High profits and cash flows can suggest the business could afford a high amount of charges.
- Shareholders may ask for cash- There is an argument that shareholders may ask for dividends for themselves if and only if the retained profits do not result in higher profits.
We hope you are now well aware of what is retained profit and why it is important. To know the financial stability of a business in a certain period, we need to retain profit.
Retained profit appears on the equity section of the balance sheet. It can be profitable in numerous ways whether it is related to increasing the stock value or providing funds. But with these advantages, it also contains some disadvantages that are mentioned above.
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