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Unlock This CourseImagine you run a successful lemonade stand and make £50 profit in your first month. You could spend all £50 on sweets, or you could keep some money to buy more lemons and sugar for next month. That money you keep is called retained profit - it's the profit a business doesn't pay out to owners but keeps for future use.
Retained profit is one of the most important internal sources of finance for businesses. It's money that belongs to the business and can be used to fund expansion, buy new equipment, or save for tough times ahead.
Key Definitions:
When a business makes profit, owners must decide what to do with it. They can either take it out as dividends or keep it in the business. The amount kept becomes retained profit, which appears on the balance sheet as part of shareholders' equity.
Understanding how retained profit is calculated helps you see where this money comes from and how much is available for business use.
Retained Profit = Net Profit - Dividends Paid
This is the profit left after all expenses, taxes and interest have been paid. It's the "bottom line" on the profit and loss account.
Money paid out to shareholders. The board of directors decides how much to pay based on company performance and future needs.
The remaining amount stays in the business as retained profit, ready to be used for future investments or kept as reserves.
TechStart Ltd made £100,000 net profit last year. The directors decided to pay £30,000 in dividends to shareholders. Therefore, retained profit = £100,000 - £30,000 = £70,000. This £70,000 stays in the business for future use.
Retained profit offers several benefits that make it attractive to business managers and owners.
Unlike loans, retained profit doesn't cost anything to use. There's no interest to pay, no monthly repayments and no pressure from lenders. It's essentially "free" money for the business.
The money is already there, ready to use. No need to apply for loans, wait for approval, or negotiate terms. Managers can make quick decisions and act fast on opportunities.
Other key advantages include:
While retained profit has many benefits, it also comes with some drawbacks that businesses must consider.
You can only retain what you've earned. If profits are low or the business is new, there might not be enough retained profit for major investments.
Keeping profits means paying smaller dividends. Shareholders might become unhappy and could sell their shares, affecting share price.
Money kept in the business might earn less than if it were invested elsewhere. Shareholders could potentially get better returns from other investments.
Additional limitations include:
Amazon famously retained almost all its profits for many years, paying no dividends to shareholders. Instead, they reinvested everything into growth, building warehouses, developing technology and expanding globally. While shareholders received no cash dividends, the company's value grew enormously, making their shares much more valuable. This shows how retained profit can create long-term wealth even without immediate cash returns.
Smart businesses know when retained profit is the best financing option and when other sources might be better.
When buying new equipment, upgrading technology, or making minor improvements, retained profit is often the perfect choice. It's quick, easy and cost-effective for smaller amounts.
When a business spots a chance to expand quickly, retained profit allows immediate action without waiting for loan approval or finding new investors.
Retained profit works best when:
Understanding how retained profit compares to other financing options helps businesses make better decisions.
Retained profit: No interest, no repayments, but limited amount. Bank loans: Larger amounts available, but cost money and require security.
Retained profit: Keeps full control, but limited by past profits. New shares: Raises more money, but dilutes ownership and control.
Retained profit: Keeps all assets, but may not provide enough cash. Asset sales: Quick cash injection, but loses valuable resources.
Maria's Pizza Palace has been profitable for three years, building up £45,000 in retained profit. Maria wants to open a second location costing £40,000. She could use her retained profit to fund most of the expansion, keeping full control and avoiding loan interest. However, this would use almost all her reserves, leaving little for emergencies. Maria decides to use £25,000 retained profit and take a £15,000 loan, balancing cost savings with financial security.
Successful businesses develop strategies for building and using retained profit effectively.
The best businesses don't just accumulate retained profit - they plan how to use it strategically for maximum benefit.
Smart companies find the right balance between retaining profits for growth and paying dividends to keep shareholders happy. This might mean paying modest dividends while keeping the majority for reinvestment.
The best businesses create retention policies, deciding in advance what percentage of profits to keep. This helps with long-term planning and sets clear expectations for shareholders.
Effective retained profit management includes:
As businesses evolve, the role of retained profit continues to be crucial for sustainable growth and financial independence.
Modern businesses increasingly value the flexibility and control that retained profit provides. In uncertain economic times, having internal funding sources becomes even more important as external finance may become harder or more expensive to obtain.
For IGCSE students, understanding retained profit is essential because it demonstrates how successful businesses can become self-funding, reducing dependence on external sources and maintaining greater control over their destiny.