Capitalization of Earnings - Explained
What is Capitalization of Earnings?
Written by Jason Gordon
Updated at October 12th, 2021
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What is Capitalization of Earnings?
Capitalization of earnings means that a company's earnings are not distributed to owners; rather, they are maintained in the company for future use. As such, the earning are capitalized or become part of the company's working capital. Capitalization of earnings allows the company to keep important resources in its possession.
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How Does Capitalization of Earnings Work?
A company needs working capital to operate and/or expand its operations. There are only three ways to finance these cash needs incurring debt liabilities to third parties, receiving new capital contributions from owners, or capitalizing earnings from operations. Financing through liabilities can be costly. It may not be easy to find creditors willing to provide resources to the company at a low cost. In addition, it is necessary to commit a large part of the assets to support these liabilities, reducing the company's financial maneuverability. Taking in new capital through the issuance of additional shares (or conducting a capital call) can either dilute or put an existing shareholders. As such, many companies choose to retain their earnings to capitalize the company and meet its future resource needs. For accounting purposes, the capitalization of the earnings is nothing more than classifying earnings as retained on the balance sheet.