Retained earnings refer to the money that’s left over after a company uses its net income to pay shareholders. Retained earnings can also be thought of as the cash reserved for reinvestment in business growth.
You need to know your beginning balance, net income, net loss, and dividends paid out to calculate retained earnings. Calculating these figures together using a specific formula provides a statement of retained earnings.
Below, we discuss what retained earnings are, share an example for how it’s used in context, and explain the formula to calculate your retained earnings.
What are retained earnings?
Retained earnings are the money that remains at the end of a company's accounting period, after paying shareholders their dividends.
When a business has a positive retained earnings number, the company has more to spend on assets to foster further growth.
Growth activities might be research and development, expanding premises, or hiring employees. Further, the retained earnings could be spent on outstanding loans, mergers and acquisitions, or improving infrastructure.
What is a statement of retained earnings?
The retained earnings statement is an essential tool for financial analysis. Depending on how your company decides to manage its finances, you might create a combined statement of retained earnings and income or a separate statement with only the company’s retained earnings.
A business's calculated retained earnings are a crucial indicator of overall financial health. Positive retained earnings are a good sign, while long-term negative figures indicate financial trouble.
Why should businesses calculate retained earnings?
Seeing your figures in detail provides insight into your company's financial health. Calculating retained earnings will provide valuable information to people you rely on to maintain a financially successful business.
Shareholders can use retained earnings to calculate share value
Shareholders profit when a company profits; they receive dividends and hold equity in the business. Shareholders can calculate the value of 1 share by dividing the retained earnings by the number of outstanding shares.
Further, figuring your retained earnings helps your company work out cash projections and draw up a budget for the year ahead, which will also be necessary to shareholders.
Creditors can use retained earnings to set loan terms
Reinvestments from retained earnings help boost future earnings, while negative retained earnings typically indicate a need to reduce spending. When creditors see a negative figure, they're less likely to grant the business a loan or may provide it, but with a higher interest rate.
Investors can use retained earnings to gauge investment risk
When investors are deciding if a business is worth investing in, the first thing they look at is the retained earnings statement for the current financial period and previous periods. The insight this provides tells them the amount of risk they're assuming by investing in the company; the less risk, the higher likelihood they’ll see a positive return on investment.
How do you calculate retained earnings?
Gather your financial statements and ensure all figures are correct before using the retained earnings formula.
Starting Retained Earnings + Loss Dividends Paid/Net Income = Total Retained Earnings
Beginning retained earnings
Retained earnings are noted on the balance sheet under accumulated income from the previous year minus shareholder dividends.
The retained earnings figure is not always a positive number. The retained earnings reflects the current period's losses, and if those are greater than the retained earnings beginning balance, the number will be negative. Also, a significant distribution of dividends may exceed the retained earnings number, leading to a negative figure.
Net income/loss
After you calculate your beginning retained earnings, you'll work out your net income. First, make sure your income statement is correct with all expenses and revenues recorded accurately. Then, calculate your income along with your loss while ensuring accuracy; double-check your figures.
Make sure you've accounted for depreciation in your net income as well. Your losses might include negative shareholder equity, which may indicate poor financial and business performance when this is the case.
Paid dividends
Figuring out dividends is often a simple step, and if you don't have investors, you can skip it altogether. Businesses that pay shareholder dividends will deduct these from their net income to figure retained earnings. Private companies, however, will not always need to pay dividends due to the nature of their ownership.
Businesses that have investors or shareholders will need to determine how they want to pay out these dividends. You can pay dividends based on retained earnings or by income percentage. Either way, the amount will be deducted from your net income when determining retained earnings.
Year-end retained earnings
Lastly, you'll calculate your retained earnings for the year.
First, always follow the retained earnings formula. Start with the beginning balance, plus your net income, subtract dividends paid, and this will equal your yearly retained earnings.
Create your statement of retained earnings. Below is an example for reference:
Professionals Inc. started with a retained earnings balance of $27,500 as of December 31, 2019. Their net income/loss total for 2020 was $31,000, and dividends to shareholders were paid out, totaling $19,250. The retained earnings as of December 31 2020, totals $39,250.
What factors impact your retained earnings balance?
Revenue increases and decreases will impact retained earnings because they affect profits and net income. A net income surplus will result in more money allocated to retained earnings after funds are put towards debt repayments, investments, and dividends. All factors affecting net income will ultimately impact retained earnings.
Essential factors to consider that would impact your net income include:
cost of products sold and production of goods sold in a business, including material costs of creating the products and direct labor and production expenses
operating expenses related to typical business operations, equipment, rent, inventory costs, payroll, marketing, insurance, and funding for research and development
revenue and sales
Net income vs. retained earnings: What's the difference?
Accounting terms can cause considerable confusion, and knowing the difference when keeping track of your finances is crucial for accuracy and financial literacy.
Retained earnings and net income are not the same. However, net income, including dividends and net losses, directly impacts retained earnings, so they are related. Net income is the total amount of money a business makes after subtracting expenses and taxes.
A business is taxed based on its net income, and retained earnings are what remains after net income is taxed. Retained earnings are not the taxed portion because tax has already been deducted from this total.
Where are retained earnings found on the balance sheet?
Balance sheets include multiple figures, and it's essential to understand where to find or input your calculations. For example, you can find or enter retained earnings on the right side of a balance sheet, next to shareholder's equity and liabilities.
A balance sheet provides insight into a business's current financial status and is only a snapshot of that moment in time. When an accounting period ends, an income statement is drafted first; then the business can decide where to allocate leftover earnings and cash.
What should you do with retained earnings?
Retained earnings can do more than provide financial insight; they can help you grow your business and enjoy more success, as well.
Pay off debts
When investors or creditors look at a company's financial statements, they'll want to know how much debt it has. Reducing debt with your retained earnings is an excellent way to get into a healthy financial standing and reduce liabilities.
The more liability a business assumes, the riskier it will be to investors, and the less likely it'll be for you to borrow money and grow your business. Alternatively, a company with lower debt, or less liability, will appear less risky and more attractive to investors.
With less debt, you should be able to borrow greater loans, pay the money back at a lower interest rate, and grow your business.
Buy fixed assets
After paying off debts, shareholders, and liabilities, your company may want to invest in fixed assets. Buying fixed assets can help expand your business to increase your profits. A fixed asset might be updated equipment, a larger office space, or more inventory.
When you're able to produce more goods and services, you should be able to expand your company and increase profits. Further, companies that can increase their profits often receive higher valuations, which can benefit owners who want to sell a company.
Buy investments
Investing is a great way to grow the worth of your business. Bonds, mutual funds, fixed deposits, stocks, real estate, takeovers, and investing in startups are all ways you can make your money work for you. Further, companies may also buy back their stock. When this happens, the stock left over — which has suddenly become rarer — often increases in value.
Save cash
Holding liquid cash is wise, as investment opportunities may come up during the year. Further, many companies decide to keep cash readily available as unforeseen expenses may come up that weren't accounted for during the initial budget.
Retained earnings FAQ
What is an accumulated deficit?
An accumulated deficit is when a company's debts total more than its reported earnings on a balance sheet.
For example, if a business generated a $30,000 profit over 2 years and then lost $10,000 over the 2 years after, the balance sheet in the 4th year would show a retained earnings total of $20,000.
What happens to retained earnings at year-end?
Retained earnings are kept by the business to reinvest towards future operations and needs and are often rolled over to the following year's beginning balance sheet. Depending on the financial position of your business, you may want to reinvest in equipment, employee salaries, or more inventory.
Can you spend retained earnings?
Yes, you can spend retained earnings. While a company often saves retained earnings to roll over into the new fiscal year, retained earnings can also be spent on reinvestments.
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