Earned surplus definition

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What is an Earned Surplus?

An earned surplus is the amount of funds generated by the operations of a business and which were retained within the organization, rather than being paid out to investors. The earned surplus is more commonly known as retained earnings. A business is more likely to have an earned surplus when it is growing rapidly, since it needs the cash to pay for its fixed asset and working capital requirements.

Characteristics of an Earned Surplus

The key characteristics of an earned surplus are as follows:

  • Accumulated profits. Represents the total profits retained by the company over time after paying dividends. It grows with profitable operations and shrinks with losses or excessive dividend payouts.

  • Part of shareholders’ equity. It is recorded under the equity section of the balance sheet.

  • Supports financial stability. It acts as a financial cushion to support the company during economic downturns or unexpected expenses.

  • Reflects profitability. A healthy earned surplus indicates consistent profitability and efficient financial management. Conversely, a declining or negative earned surplus may signal operational inefficiencies or excessive losses.

  • Linked to dividend policy. An earned surplus determines a company’s ability to pay dividends to shareholders. Companies with substantial earned surplus are more likely to distribute dividends, though some may prefer reinvestment.

  • Non-cash account. An earned surplus does not represent actual cash reserves, but rather the cumulative profits reinvested into the business.

  • Legal restrictions. In some jurisdictions, laws may restrict the use of earned surplus for dividend distribution to protect creditors and ensure financial stability.

Example of Earned Surplus

Hilltop Corporation has been in business for five years, and has accumulated an earned surplus of $2 million over that period. In the current year, it generates $300,000 of net income. This amount is added to its beginning earned surplus, resulting in an ending earned surplus of $2.3 million.

The Hilltop board of directors notes that the growth of the company is leveling off, so it no longer needs as much working capital to maintain its operations. Accordingly, the board decides to free up some cash for the investors, and authorizes a $200,000 dividend to them. The dividends are issued a few months later, resulting in a remaining earned surplus of $2.1 million.

In effect, the ongoing earnings of the company have gradually increased its earned surplus, while any dividend payouts reduce the earned surplus balance. If the board continues to authorize dividends, then it is likely that any future profits earned by the business will be roughly offset by outgoing dividend payments, resulting in a fairly steady earned surplus balance.