## Retained Earnings

### Definition

The portion of profits not distributed as dividends but reinvested (ploughed back) into the business. An internal, long-term source of finance.

### Key Characteristics

Characteristic	Explanation
Belongs to shareholders	Adds to net worth; increases shareholders' equity without issuing fresh shares
No dilution of control	No new shares issued → existing control remains intact
Cost-effective	No flotation cost, no interest obligation, no external risk
Used for expansion	Capital expenditure, diversification, modernisation
Legally required	Public companies must retain a reasonable portion annually
Opportunity cost applies	Retention is justified only if reinvested return > cost of equity capital

### The Opportunity Cost Concept

Retained earnings are not free — shareholders forego dividends when earnings are retained. The cost of retained earnings ≈ the return shareholders could earn elsewhere (opportunity cost). If the company cannot earn more than this benchmark, it should distribute rather than retain.

### Advantages

No external dependency
No dilution (ownership or EPS)
Flexible — management decides how much to retain
Strengthens balance sheet

Worked example

### Example 1

Example: A company earns ₹50 lakh profit. It retains ₹30 lakh and pays ₹20 lakh as dividend. The ₹30 lakh retained is used to buy new machinery. No new shares were issued, so EPS and control are preserved — illustrating the strength of retained earnings.

### Example 2

Example: Shareholders expect 15% return on their investments. If the company retains profits and reinvests at only 10%, it has not covered its opportunity cost — shareholders would have been better off receiving dividends and investing themselves. This is why opportunity cost discipline is critical.

⚠️ Common exam mistakes

Calling retained earnings 'free' — they carry opportunity cost equal to the shareholders' required return.
Confusing retained earnings with cash reserves — retained earnings are an accounting concept (part of equity); actual cash position depends on asset deployment.
Saying retained earnings dilute control — they do not, since no new shares are issued.

Reference:

Now that you've read this — what's next?

Move from understanding → mastery in 3 clicks. Each option below picks up from this lesson's topic.

🔥 Drill 5 Qs on this → ✍️ Adaptive practice →

Retained Earnings as a Source of Finance

Worked example

⚠️ Common exam mistakes