It is important for a company to operate economically and of course to make a profit. In many cases, the profits are then distributed, for example to the shareholders of a company. But there are also cases in which profits are withheld. In this case one speaks of a retention of profits .
What is retention of income?
According to healthknowing.com, retention of profits is understood as the retention of profits by companies or fund companies that have been generated in the course of a period. Retention of profits is to be understood as a business process in which profits are not distributed to shareholders through, for example, a distribution of dividends. Rather, the retention of profits ensures that the company’s equity is increased in order to create funds for investments.
What is the purpose of retained earnings?
The retention of profits is part of the self-financing of a company . This means that the retention of profits ensures more independence, on the one hand to avoid borrowing or an external capital increase and on the other hand to improve equity. With the retention of profits
- can leverage to reduce a company
- the creditworthiness of a company can be improved
This means that it is much easier to take out loans later. Another great advantage is that with internal financing through retained earnings, there are no repayment periods and no interest. There are also no additional costs for raising capital. The funds arising from the retention of profits are available to you as an entrepreneur over the long term. The disadvantage, however, is that shareholders must agree to the retention of profits.
What types of accumulation are there?
A distinction is made between two types of accumulation.
- Open accumulation: The open accumulation is shown directly on the company’s balance sheet.
- Concealed accumulation: With concealed accumulation, so-called hidden reserves are created. This happens either by undervaluing liabilities or by overvaluing assets.
What are the goals of retained earnings?
The goals of retained earnings are to distinguish between the goals of a shareholder and the goals of the company. Above all, of course, is the company’s goal of generating profits. The shareholder hopes that the profits will be distributed to himself. The company, on the other hand, is pursuing the following goals.
| Corporate goals | Description |
| Striving for independence | With the profits generated, a company can strengthen its capital base by retaining profits. Investments can be made without borrowing like various loans. It is also not necessary to involve other shareholders. This is particularly evident in the leading technology groups in the USA. They have a lot of equity and a lot of free liquid funds. This enables them to expand freely in the market. With the retention of profits, you create a high degree of independence. |
| Cost reduction | By creating equity through retained earnings, companies can reduce costs. If borrowing is not required, there are no costs for interest, fees or repayments. With the creation of equity, it is also possible for listed companies to buy back their own shares on the market. This increases the value of the share. |
| Increase competitiveness and reputation | A company with a high share of equity is much better protected against takeovers by other companies. They are more competitive and stay at the top for much longer. In addition, it is much easier for such companies to hire highly qualified personnel. This ensures competitiveness, profitable growth and the company’s reputation in the long term. |
How should profit retention be viewed from a tax and accounting point of view?
Every partnership or sole proprietorship books profits through retained earnings in the capital account. A separate disclosure in the balance sheet is not necessary. In the case of corporations , the profit from retained earnings is posted to the balance sheet through reserves . According to Section 58 of the German Stock Corporation Act , it is possible for the management board and the supervisory board to use half of the surplus within a period of the AG to retain profits. This significantly improves the scope of action of an AG, because the consent of the shareholders is not required.
From a tax point of view, the profits from the retention of profits are favored by a lower tax rate compared to a distribution of profits. In technical terms, this is called a retention allowance . This is particularly true of partnerships and sole proprietorships. Compared to a stock corporation, there is a much smaller disadvantage here and makes the formation of equity easier. This was regulated in the corporate tax reform in 2008.
Retention of profits in mutual funds
In mutual funds , the profit retention plays a special role. Here you have to differentiate between a distributing fund and an accumulating fund. In the case of the distributing fund, the profits generated are regularly paid out to the investors. The situation is completely different with the accumulating fund. The winnings are retained here. However, this is by no means a disadvantage, as it allows the fund assets to be increased steadily. For an investor, this is noticeable through an increase in their share values.
Summary
- The term retained earnings is used to describe the retention of generated profits
- By retaining profits, a company improves its capital structure and thus gains a better credit rating.
- Retaining earnings is a great way to build more equity and make investments easier.
- By retaining profits and building more equity, companies become more independent in the long term and significantly increase their competitiveness in the market compared to companies with little equity.
- In the case of investment funds that do not distribute profits, we speak of accumulating funds
- Corporations and sole proprietorships are given preferential tax treatment over stock corporations when it comes to retaining profits. They benefit from the so-called accumulation discount.
Conclusion
Retaining profits is often referred to as the silver bullet that leads to long-term security for a company. This makes more growth possible, profits rise steadily and the market position is strengthened or expanded. This way, profitable companies gain significantly more independence because they are only slightly dependent on outside funds. Compared to a company with little equity, such companies always have a great advantage.