If you're in business, chances are good that one of your primary motivations is to make money. However, you can't spend all of the company's profits on bonuses for the upper management or payouts to shareholders, or you run the risk that your business will soon fall behind and be in the red. Able managers will use a percentage of annual profits to keep their businesses competitive. This capital is sometimes referred to as reinvested income or, more commonly, retained earnings.
Reinvested Income Vs. Dividends
After all operating costs and overhead have been assessed for the year, a company is left with its net profits, or the amount of money it made above and beyond the money it spent. A company has two primary things that it can do with this money. One is to pay out dividends to the shareholders who have a stake in the company. The other is to somehow reinvest the money in the company.
Reasons for Reinvesting Income
Companies use reinvested income for a variety of purposes. A company may reinvest a portion of income into activities designed to expand its customer base, such as advertising, product development or the purchase of real estate that allows expansion into new geographical territories. Reinvested income may also be used to expand and improve a company's workforce by hiring and training new workers, to purchase new equipment, or to maintain, repair or improve a company's existing facilities.
Shareholders and Reinvested Income
Although it is company managers who ultimately decide what percentage of profit to pay out and what percent to reinvest, their decisions are still subject to shareholder oversight. The purpose of reinvesting income is to improve a business so that it makes even more money in the future. Shareholders could make a minimal return on their money by simply investing it in a savings account. If a company withholds a portion of their earnings to reinvest in the business, shareholders expect to see a better eventual return on their money than if it was sitting in a savings account. Managers who fail to make profitable use of reinvested income may find themselves replaced by disgruntled shareholders.
What Reinvested Income Means to Potential Investors
On a balance sheet or profit and loss statement, retained earnings appear as the portion of profit that remains after a company pays its taxes and issues dividends to its stockholders. The amount of retained earnings that are reinvested in a business means different things to different investors. Some may take a low ratio of reinvested income to dividend payouts as a sign of confidence. On the other hand, other investors may see a high level of reinvested income as positive because it indicates that a company has had a history of success and profitability.
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