Retained Earnings Breakpoint: Definition and How to Calculate It

For most companies and businesses, profitability is one of the most critical success metrics. Most stockholders in companies focus on their profit-making ability. This profit is not only crucial for distributing among shareholders but can also provide a source of finance. Companies may choose to either hold their profits or distribute them to their shareholders. In practice, companies establish a ratio for retaining profits.

What are Retained Earnings?

Retained earnings represent any profits that companies hold for internal use. When a company makes profits, it can choose to retain it if it has any future projects. It may do so because profits generated internally are significantly inexpensive. Holding profits also helps companies avoid obtaining new finance such as debt or equity.

Retained earnings also show a company’s accumulated profits that it has not distributed to its shareholders. This figure is available in the balance sheet. Financial statement users can interpret a company’s retained earnings as the total of its profits that it has held since its inception. Companies may also choose to distribute these earnings to their shareholders. Usually, however, retained earnings are used for reinvestment.

How Do Companies Calculate Retained Earnings?

Retained earnings comprise any profits that companies hold after distribution to shareholders. Usually, every company has a set percentage for distributing earnings. Stable companies have a lower retention ratio compared to newly-established companies. Usually, it is because stable companies do not require substantial capital reinvestment.

At the end of each period, companies calculate their retained earnings closing balance. They can do so by taking the opening balance and adding any profits generated during that period to the amount. Once they do so, companies must deduct any distribution to shareholders from this balance. The distribution may either be in cash or stocks.

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For companies that have a retention ratio establish, the calculation of retained earnings is straightforward. These companies can calculate their retained earnings by multiplying their total earnings with the retained ratio percentage. Usually, however, this ratio may not be fixed and changes according to a company’s capital requirements.

What is Retained Earnings Breakpoint?

Retained Earnings Breakpoint represents the amount of new capital that companies can raise before altering their capital structure. Companies that exceed this limit must raise additional equity to reestablish their capital structure. This additional capital raised can be costly and increase a company’s Weighted Average Cost of Capital (WACC).

The reason why companies calculate and set a retained earnings breakpoint is because of the cost of capital. Companies always focus on reducing this cost. For that purpose, they establish an optimal capital structure level for debt and equity. Any changes to this structure can cause an increase in costs. Therefore, companies try to focus on the retained earnings breakpoint.

Retained earnings play a critical role in establishing the breakpoint. When companies raise additional finance, they always try to consider the capital structure. However, retained earnings limit this strategy. In short, retained earnings breakpoint represents the amount of new capital that companies can raise without altering their target capital structure.

How to Calculate Retained Earnings Breakpoint?

Companies can calculate the retained earnings breakpoint by using the following formula.

Retained Earnings Breakpoint = Retained Earnings / We

The retained earnings in the above formula represent a company’s retained earnings available in its balance sheet. “We”, on the other hand, represents the weight of equity in a company’s capital structure. Companies can calculate this percentage by dividing the total equity by its total equities and liabilities.

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Example

A company, ABC Co., made total earnings of $30 million in the last accounting period. The company’s retention ratio is 70%. The company’s capital structure consists of 60% equity and 40% debt. Before calculating ABC Co.’s retained earnings breakpoint, it is crucial to calculate its retained earnings for the period.

Retained Earnings = Total Earnings x Retention Ratio

Retained Earnings = $30 million x 70%

Therefore, Retained Earnings = $21 million

Therefore, ABC Co.’s retained earnings breakpoint will be as follows.

Retained Earnings Breakpoint = Retained Earnings / we

Retained Earnings Breakpoint = $21 million / 60%

Therefore, Retained Earnings Breakpoint = $35 million

Therefore, the company can raise further capital of $35 million before issuing new ordinary shares. In case its additional capital requirement exceeds this $35 million, the company may either use debt or equity finance to reestablish the structure. Either way, ABC Co. will experience an increase in its weighted average cost of capital.

Conclusion

Retained earnings represent a company’s accumulated profits after distributing to its shareholders. Retained earnings breakpoint shows the amount of additional capital that companies can raise without altering their capital structure. When a company exceeds this point, it will have to raise new capital through either debt or equity. This additional capital can cause an increase in the weighted average cost of capital.

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