Retained earnings is the total profit your company has kept since it started, after tax and after dividends. It is an equity figure on the balance sheet, not a bank account. The cash it represents has usually been spent on debtors, stock, equipment and loan repayments, which is why the number is large and the bank balance is not.

This is the single most common misunderstanding we deal with. An owner sees $363,900 of retained earnings on their balance sheet and reads it as money waiting for them. It is not. It is a record of profits already earned and already spent on something else.

I am Mina Baselyous, a Certified Practising Accountant (CPA) and Chartered Tax Advisor (CTA) in Melbourne. This article explains what the figure actually represents, traces exactly where the money went, and sets out the legal test a company has to pass before it can pay any of it out.

What Retained Earnings Actually Is

Retained earnings sits in the equity section of the balance sheet, underneath share capital. It is the running total of every dollar of after-tax profit the company has ever made, less every dollar it has paid out to shareholders as a dividend. It is a historical record, not a fund.

The confusion is understandable, because the word earnings sounds like money. Think of it instead as a score. It tells you how much value the business has generated and kept over its life. What the business did with that value, whether it turned into cash, machinery, stock or unpaid customer invoices, is shown on the other side of the balance sheet entirely.

You may also see it called accumulated profits, retained profits or, if it is negative, accumulated losses. They all mean the same thing. If you are new to this report, read our guide to reading a balance sheet first, because retained earnings only makes sense in the context of the whole statement.

The Formula and the Roll Forward

Opening retained earnings, plus profit after tax for the year, less dividends declared, equals closing retained earnings. That is the whole formula. Every year it rolls forward, which is why a business that has traded for fifteen years carries fifteen years of decisions in one line.

Using the same Melbourne trade and services company from the balance sheet and cash flow guides:

The 25 per cent rate applies because this is a base rate entity. As set out in the ATO’s company tax rates, for 2021-22 and later income years a company pays 25 per cent if its aggregated turnover is under $50 million and no more than 80 per cent of its assessable income is base rate entity passive income. Every other company pays 30 per cent.

So Where Did the Money Actually Go?

The company has $363,900 of retained earnings and $42,000 in the bank. The missing $321,900 has not vanished. It is sitting on the asset side of the balance sheet, converted into things the business needed, and partly offset by what the business owes. Here is the trace.

That is the answer to the question. The profit is real and the business genuinely kept it. It is simply held as customer invoices, stock and equipment rather than as cash. Nearly two thirds of it, $630,000 of debtors and stock, is working capital that could be released with better process rather than more sales, which we cover in our guide to working capital.

In practice, says Mina Baselyous (CPA, CTA, Registered Tax Agent), once an owner sees this table the conversation changes permanently. They stop asking where the money went and start asking how to get less of it stuck in debtors and stock next year. That is the whole point of reading the reports together.

Can I Just Pay It Out? The Section 254T Test

No, not automatically. Section 254T of the Corporations Act 2001 says a company must not pay a dividend unless three conditions are all met: assets exceed liabilities immediately before the dividend is declared and the excess is sufficient to pay it, the payment is fair and reasonable to shareholders as a whole, and it does not materially prejudice the company’s ability to pay its creditors.

Note what that test is not. It is not a profits test, and it has not been one since 2010. A company with large retained earnings can still be prohibited from paying a dividend if the net assets test fails or if paying it would leave creditors exposed. The Act’s own note gives the obvious example: a dividend materially prejudices creditors if the company would become insolvent as a result.

There is a practical limit on top of the legal one. Our example company has $364,000 of net assets and passes the first test comfortably, but only $42,000 of cash. Declaring a $300,000 dividend would be legally arguable and commercially reckless. Directors who ignore that distinction can face personal exposure under the insolvent trading provisions, which is the same territory we covered in our article on director penalty notices.

Three Different Limits, and They Are Not the Same Number

Before you pay a dividend, three separate constraints apply and they rarely agree. Retained earnings tells you what profit has been accumulated. The franking account tells you how much tax has actually been paid and therefore how much of the dividend can be franked. Cash tells you what you can physically transfer. You need all three.

• Retained earnings. The accounting measure of accumulated profit, and the starting point for the section 254T net assets test.
• The franking account balance. Built up from company tax actually paid. Pay a dividend larger than your franking account supports and it comes out partly or wholly unfranked, taxed in the shareholder’s hands with no credit. The ATO explains the mechanics in its guidance on allocating franking credits.
• Cash. The only one that actually constrains the bank transfer. A dividend declared but not paid becomes a loan owing to the shareholder, which has its own consequences.

There is a fourth trap. If you simply take money out without declaring a dividend or paying a wage, you have created a loan from the company to a shareholder, and that is Division 7A territory. Left unaddressed it becomes a deemed unfranked dividend, which is the worst of all available outcomes. Our guide to paying yourself from your company tax-effectively sets out the legitimate routes.

Negative Retained Earnings

If the figure is negative, the company has accumulated more losses than profits over its life. This is common in early years and after a bad trading period, and it is not automatically fatal. What it does mean is that the section 254T net assets test becomes much harder to satisfy, so dividends are usually off the table until the position recovers.

It also matters for tax. Carried forward tax losses are a separate concept from accumulated accounting losses, and using them in a later year depends on satisfying continuity of ownership or the business continuity test. If your shareholding has changed, get advice before assuming the losses are still available.

What Established Owners Actually Do With Retained Profits

Leaving years of accumulated profit sitting inside a trading company is a decision, and usually not a deliberate one. Those profits are exposed to every risk the trading business carries: a customer dispute, a workplace claim, a bad debt, an insurance gap. The strategic question is not just how to extract them, but where they should sit.

• Pay franked dividends deliberately. Planned across years rather than in one lump, so the shareholder’s marginal rate is managed rather than spiked.
• Use a corporate beneficiary. Where a trust is in the group, a bucket company can cap the tax on retained profits at the company rate rather than the top marginal rate.
• Separate the profits from the trading risk. A holding company lets surplus profits be paid up out of the operating entity so they are not exposed to its liabilities.
• Fund growth or debt reduction consciously. Retaining profits to buy equipment or pay down loans is a legitimate strategy, but it should be a choice with a plan, not a default.

Which of these is right depends entirely on your structure, your risk profile and your timeframe, and getting it wrong is expensive to unwind. It belongs in a tax planning conversation in April or May, not in the week before 30 June.

What to Do Next

Find the retained earnings figure on your latest balance sheet and compare it to your cash at bank. If there is a large gap, build the trace table above from your own numbers so you can see exactly which assets your accumulated profits turned into. That single exercise resolves most of the confusion.

Then ask the two questions that follow: how much can legally and safely come out, and where should the rest sit. Read this alongside our guide to the cash flow statement, which shows the same story as a movement rather than a balance, and consider whether a monthly reporting rhythm through a Virtual CFO engagement would have surfaced this earlier.

Frequently Asked Questions

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