What impact does paying a dividend have on retained earnings?

When a company pays a dividend, it distributes a portion of its earnings to shareholders. This action directly reduces the amount of retained earnings. Retained earnings represent the accumulated profits that a company has reinvested in the business rather than distributing to shareholders.

When dividends are declared and paid, the total equity of the company is affected as follows: cash (or other assets) is given to shareholders, thus reducing the retained earnings account and reflecting the outflow of resources from the company. Unlike net income, which increases retained earnings, paying dividends shows a distribution of those earnings, leading to a decrease in retained earnings.

Understanding this is crucial for analyzing a company's financial health, as a decrease in retained earnings can indicate that the company is returning profits to shareholders rather than reinvesting in growth opportunities.