Earned capital, also known as retained earnings, represents the portion of net income of a company that is retained by the company rather than distributed to its shareholders as dividends. It’s a part of shareholders’ equity in the balance sheet and shows the total profits that have been reinvested in the business since its inception.
Earned capital can be used in various ways to benefit the company, including:
- Funding new projects or investments
- Paying off debt
- Purchasing equipment or assets
- Funding research and development
- Building up a reserve for future financial stability
When a company’s earned capital is positive, it generally indicates that the company has been profitable over time and has chosen to reinvest those profits rather than pay them out in dividends. If earned capital is negative, it could indicate that the company has sustained losses or has distributed more in dividends than it has made in profits.
It’s important to note that earned capital only comes from operational and investment activities of the company, distinguishing it from other forms of capital such as contributed capital (also known as paid-in capital), which comes from investors in exchange for stock.
Example of Earned Capital
Let’s consider a hypothetical company, Company ABC.
Company ABC was founded five years ago and had a net income (after all expenses and taxes) of $100,000 in each of those years. Each year, it paid out $20,000 as dividends to its shareholders. The remaining $80,000 per year was not distributed and was retained by the company.
So, over five years, Company ABC has accumulated earned capital (retained earnings) of $400,000 ($80,000 * 5).
Now, let’s say that in the sixth year, Company ABC had a net income of $150,000 and paid out $30,000 in dividends. The remaining $120,000 would be added to the earned capital.
So, at the end of the sixth year, the total earned capital for Company ABC would be $520,000 ($400,000 + $120,000).
This accumulated earned capital is a source of funding that Company ABC could use to invest in new projects, expand its operations, purchase new assets, pay off debt, or save for future use. It represents the total profits that have been earned and reinvested in the company over its history.