When companies need to raise money for things like product development, equipment purchases, or expansion, they can do so in one of two ways: They can seek to borrow money from lending institutions, or they can issue stock to the public. Stocks represent an ownership share in a company, and as such, stockholders are entitled to receive a portion of the issuing company's earnings.
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Common stock is a type of stock that companies issue. Those who hold common stock have voting rights in a company, which means that they have a say in corporate policy and decisions. Preferred stockholders, by contrast, do not have voting rights, though they have a higher claim on earnings than holders of common stock. Common stockholders can make money by collecting dividends, which are a portion of a company's earnings that it chooses to share.
Retained earnings represent the portion of a company's net income during a given accounting period that isn't paid out to stockholders as dividends, but rather, is retained to reinvest in the business. Retained earnings are recorded under shareholders' equity on a company's balance sheet. A company might choose to retain its earnings to develop new technology, upgrade its software, or acquire smaller competing companies. Retained earnings are calculated by taking the beginning net earnings balance during an accounting period, adding the company's net income during that period, and subtracting the amount of dividends paid to stockholders. If a company starts the year with $1 million in retained earnings, has a net income of $1 million, and pays out $200,000 in dividends, its new retained earnings figure would be $1.8 million.
Growing companies often choose to avoid dividend payments and instead retain as much of their earnings as possible to help fuel their development. Retained earnings can also be used to pay off debt, and as such, some companies use their retained earnings for this purpose instead of paying out dividends.
Common stock and retained earnings
When a company issues common stock to raise capital, the proceeds from the sale of that stock become part of its total shareholders' equity but do not affect retained earnings. However, common stock can impact a company's retained earnings any time dividends are issued to stockholders. When a company pays dividends, it must debit that payment to retained earnings, which means its retained earnings balance will drop by the value of the dividends it has issued.
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