Risk and uncertainties are part and parcel of every business. How well a business makes preparation to handle these risks and uncertainties is what decides how successful a business is and how best it is placed to fight and sustain a downtrend. Retained earnings and reserves are two very important weapons that businesses have to face such risks and uncertainties. Though both refer to the funds (or savings) that businesses have at their disposal, the two are different from each other. Thus, to use these two tools effectively, managers must understand and know the difference between retained earnings and reserves.
To know the difference between retained earnings and reserves, it is important to understand what the two terms mean.
It represents the cumulative earnings of a firm since starting operations. Or it is the leftover part of the net profit after paying dividends to the shareholders of the company. We can also call it accumulated profits or surplus. The main objective and purpose of maintaining retained earnings are to ensure the solvency of a firm. And make it able to withstand any adverse business situation.
A company basically reinvests such funds back into the business or uses them to pay the debt. Also, these funds help companies to meet unforeseen expenditures. The quantum of profits a company retains out of its profits is the inter-play of two inter-connected ratios or metrics. These are the dividend payout ratio and the retention ratio. If a company makes a loss but still plans to distribute dividends, it can do so by using the retained earnings of the past.
One can calculate retained earnings using the below formula:
Retained Earnings = Retained Earnings at the start of the year plus Net Income for the current year less Dividends
Reserves are also a component/part of profits, but they are set aside for a specific purpose. Companies also maintain reserves to make up for future unforeseen losses. The reserves help to make a company’s financial position stronger. Companies transfer funds to reserves from the profit after paying taxes but before distributing dividends. There can be many types of reserves, but the two most popular ones are revenue reserve and capital reserve. The financial reserve, highly liquid in nature, is called dry powder in finance.
Difference Between Retained Earnings and Reserves
Now that we know what the two terms mean, let us take a look at the difference between retained earnings and reserves:
Retained earnings are part of the profits that remain after giving dividends to the shareholders. On the other hand, reserves are part of the profit that a firm sets aside for a specific purpose before paying dividends.
The main purpose of retained earnings is to reinvest profits back into the core operations and generate further growth. On the other hand, reserves help to meet unexpected specific or general expenses, such as litigation expenses, the redemption of debentures, replacement of plant & machinery, and more.
Current Year Profit
After deducting the dividend amount, we add profit for the year to the retained earnings accumulated balance. On the other hand, we transfer a certain percentage of the current year’s profit (before distributing dividends) to the reserves account.
There can be different types of reserves, such as capital reserve, revenue reserve, and many more. However, there is no such further classification of retained earnings.
Funds towards retained earnings are transferred after paying dividends from the profits. On the other hand, companies transfer funds to reserves before paying dividends from profit.
Of Course, there are some differences between retained earnings and reserves; the two are largely similar. First, Both are part of the Shareholder’s Equity. Secondly, both these funds find a place on the liabilities side of the balance sheet under the head of Reserves & Surplus. Thirdly, both help a company face uncertainties and risks and strengthen its financial position.
The only significant difference between retained earnings and reserves is in terms of their usage, i.e., how we ultimately use these funds. And the Companies use retained earnings for business activities, while reserves help meet unforeseen future expenses or future specific requirements.