Undistributed profit and how to determine it

Undistributed Profit  is earnings that are retained in the business at the end of the financial period. In other words, as the name suggests, it is that income which is not distributed to the owners of the business.

Undistributed Profit  applies as per the retention ratio of the organization such that if the ratio is big, more amounts are retained by the business and the vice versa is true.

Undistributed Profit is required by the management especially when there is need for business expansion.

Undistributed Profit  is necessary for the sake of increasing the owners’ wealth/capital base.

Undistributed Profit  is used by the management for financing purposes for it is a cheap source of finance.

How to determine Undistributed Profit 

Undistributed Profit  are determined by considering the profits made in the year end and then a certain proportion is subtracted for other purposes other than distributing the same to the owners of the company.

Example

Silicon co ltd. Provided you with the following accounting information for the year ended 31st/12 2020

Earnings before Interest and Tax  (EBIT)                              $120,000

Additional information

Interest pain on debentures for the year ended was  $30,000

Tax rate is 40% per annum

The management has a retention policy of 20%

Preference and ordinary share dividends paid were $22,000

Required

Determine the amount of Undistributed profits for the year ended 31st/12/2020

Solution

Note that, undistributed profits is as good as retained earnings and we will use the retention ratio whose formula is

to determine the undistributed profits as follows;

NB: that the aforementioned formula is as good as Retention Ratio = 1- Dividend Pay Out Ratio.

Retention ratio means the amount of profits that is ploughed back in to the business. in this case above, it shows that 69% of the profits after tax (what we call PAT or Net income) is undistributed profit for it is not paid out to shareholders in terms of dividends.