What is retained profit?

How does retained profit build up?

Each year a company makes a profit, pays Corporation Tax on it, and decides how much of what is left to pay out as dividends. Whatever is not paid out is added to retained profit. A loss, or a dividend larger than the year's profit, reduces it.

It is the running total from the day the company was formed, which is why it is sometimes called profit and loss reserve or accumulated profit. It sits in the equity section of the balance sheet, alongside share capital, and together they are what the shareholders own.

Its main practical use is that dividends can only be paid out of it. A company with no retained profit cannot lawfully pay a dividend, however much cash happens to be in the bank.

A worked example

A two-director consultancy makes £30,000 profit after Corporation Tax in its first year and pays £12,000 in dividends. Retained profit at the year end is £18,000.

In year two it makes £25,000 after tax and pays £20,000 in dividends. Retained profit rises by £5,000 to £23,000. In year three it makes a £4,000 loss and pays no dividend; retained profit falls to £19,000. That £19,000 is the most it could distribute at that point, whatever the bank balance says.

Is retained profit the same as cash?

No, and confusing the two is how directors pay illegal dividends. Retained profit is an accounting total. The money it represents may have been spent on equipment, be tied up in unpaid invoices, or already be owed to HMRC for VAT. A company can have £19,000 of retained profit and £2,000 in the bank, or the reverse. Check both before paying a dividend.