Definition of Retained Earnings to Assets Ratio
Retained Earnings to Total Assets is a ratio that measures accumulated earnings over the total assets possessed by the company. It mainly represents the total assets that are funded by the retained earnings of the organization. The retained earnings to assets ratio indicate the management’s approach towards using the accumulated profit towards reinvesting in the company as compared to paying dividends to the shareholders.
It is also representative of the management’s intent to utilize debt, or new shares to invest in the assets of the company.
Younger organizations tend to have a lower Retained Earnings to Assets Ratio since they do not generate enough profits till the reporting date. The profit that is incurred in a given year increase the amount of retained earnings, and the loss reduces the balance of the retained earnings. Therefore, organizations that are not as financially stable tend to have lower retained earnings that cannot be utilized for expansion-related projects of the company.
Explanation of Retained Earnings to Assets Ratio
Retained Earnings to Total Assets Ratio is a resourceful metric that is used by stakeholders (both internal, as well as external) in order to gauge the financial health of the company. Despite the fact that this ratio alone is not a testament to the sound financial position of the company, it is still an important tool from the perspective of the organization.
Retained Earnings are considered to be the wealth that is owned by the shareholders of the company. It is meant to be distributed to the shareholders in the form of dividends, as compensation for their investment in the company. In case an organization chooses to retain earnings, and not distribute them as dividends, it implies that the organization holds back resources for the company for expansionary purposes.
When organizations make profits, they normally do not distribute all the earnings as dividends. In fact, some of it is held back. The extent to which funds are retained depends on the future outlook of the company and the discretion of the decision-makers of the company.
Using retained earnings along with total assets helps analyzers to compare the percentage of total assets that are covered by retained earnings. Hence, total assets, i.e. the total wealth of the company, are compared with the retained earnings of the company. The ratio indicates the extent to which the company retains its profits, and uses them to finance its assets, as compared to paying out dividends.
Formula for Retained Earnings to Assets Ratio
In order to calculate retained earnings to assets, the following formula is used:
Retained Earnings to Total Assets Ratio = Retained Earnings / Total Assets
In the formula above, it can be seen that Retained Earnings are accumulated over the course of time, and these accumulated earnings are used in the formula above. In the same manner, total assets include both, Current Assets and Non-Current Assets that are possessed by the company over the course of time.
Example of Retained Earnings to Assets Ratio
The example of retained earnings to assets ratio is illustrated below:
Freebie Inc. is a cycle manufacturer based in Colorado. They have the following balances as at 31st December 2020. These balances are as follows:
|Total Current Assets||230,000|
|Total Liabilities and Equity||650,000|
In the example mentioned above, it can be seen that retained earnings to asset ratio for Freebie Inc. can be calculated as follows:
Retained Earnings to Total Assets = 250,000 / 300,000 = 0.83
This implies that Freebie Inc. has good coverage pertaining to its retained earnings and its total assets.
Let’s assume that the competitor of Freebie Inc., Goofy Co, has a Retained Earnings to Total Assets ratio equivalent to 0.5. This implies that in comparison, Freebie Inc. has better-Retained Earnings to Total Assets compared to Goofy Inc.
Analyzing Retained Earnings to Assets Ratio
The ideal ratio of retained earnings to total assets is assumed to be 100 percent. However, it is unrealistic, and almost impossible to achieve this ratio. Hence, a more realistic approach adopted by companies is to ensure that this particular ratio is pushed as closer to 100% as possible.
From an organization’s standpoint, it can be seen that companies try to maintain their retained earnings to total asset ratio at par with their competitors (i.e. the industry average). The trajectory, however, should be promising and increasing with due course of time. It must also be noted that this particular ratio highly varies across different industries. For some industries, this ratio is closer to one, whereas, for others, a ratio below 0.5 is also acceptable. In the same manner, for organizations that are debt-centric, retained earnings are highly possible, whereas, for organizations that have zero debt, the retained earnings to total asset ratio might be below. This is because companies that do not take on debt do not have options to fuel their expansion other than using their own retained earnings.
Here are a few general rules pertaining to analysis and interpretation of Retained Earnings to Assets Ratio:
- If the ratio is closer to 0, it implies the company relies 100% on debt and shareholder’s capital. This might also mean that the company is not yet making a profit, and therefore, they do not have sufficient funds to reinvest in the business.
- If the ratio is closer to 1, it implies that the company is relying solely on retained earnings to operate and invest. It is impossible to achieve this in real life.
- If the ratio is greater than 0, but less than one, i.e. somewhere around 0.5, it implies that partial assets are funded by retained earnings, whereas the rest of the assets are funded by debt or share capital.
Implications of a higher retained earnings to asset ratio
There are numerous positive implications of a higher retained earnings to asset ratio. These advantages are as follows:
- Reduced chances of bankruptcy: Since higher retained earnings to asset ratio implies that companies use their own funds to fuel expansion, this implies that they have not raised funds from external sources. This is an indicator of self-sufficiency within the business, and therefore, it is regarded as a financially sound company, with lesser chances of bankruptcy.
- Long-term funding: Retained Earnings are considered as a source of long-term funding, as compared to debt. When companies rely on retained earnings, they use these funds to invest for a longer period of time, without having to worry about finance costs, and payback periods. Therefore, it is considered as an important venture that can help companies fuel expansion, without having to worry about collaterals, and pay backs.