Most business owners are familiar with the term “net income.” But what about “retained earnings?”
This financial metric is just as important as net income, and it’s essential to understand what it is and how to calculate it. This article breaks down everything you need to know about retained earnings, including its formula and examples.
What are retained earnings and what is their purpose?
Retained earnings are the portion of a company’s net income that is not paid out as dividends. Retaining earnings help provide the company with funds for future growth and expansion, including investments in new facilities, equipment, or technology.
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While paying dividends to shareholders is one way to use profits, aiming for higher retained earnings can be a more effective long-term strategy for creating shareholder value.
In addition to providing the company with capital for growth, retained earnings also help improve its financial ratios, such as its return on equity. As a result, companies that retain a large portion of their profits often see their stock prices increase over time.
Retained earnings vs. reserves
Both retained earnings and reserves are essential measures of a company’s financial health. Retained earnings are the profits a company has earned and retained over time, while reserves are funds set aside for specific purposes, like contingencies or dividends.
The two measures differ in several ways. Companies can use reserves for any purpose they see fit, while they must use retained earnings to finance their operations or reinvest in the company. And while retained earnings are always publicly disclosed, reserves may or may not be.
Retained earnings vs. cash flow
While they may seem similar, it is crucial to understand that retained earnings are not the same as cash flow. Retained earnings represent the profits a business generates over time, while cash flow measures the net amount of cash/cash equivalents coming and and out over a given period of time.
The retained earnings formula
Here’s how to perform a retained earnings calculation:
Beginning Equity + Net Income – Net Losses – Dividends Paid Out
You can do this calculation on a quarterly or annual basis. By subtracting dividends from net income, you can see how much of the company’s profit gets reinvested into the business.
If a company has a high retained earnings percentage, it keeps more of its profits and reinvests them into the business, which indicates success.
Conversely, if a company has a low retained earnings percentage, it may indicate that it isn’t reinvesting enough of its profits back into the business, which could be cause for concern.
How do accountants calculate retained earnings?
You calculate retained earnings as the total of all profits and losses minus dividends paid out or allocated. Profit and loss are determined by accounting for sales revenue, cost of goods sold, operating expenses, taxes, and any other gains or losses associated with the business.
To arrive at retained earnings, the accountant will subtract all dividends, whether they are cash or stock dividends, from the total amount of profits and losses.
It’s important to note that if any additional amounts, such as capital contributions, have been added to the company’s account during a given period, you should deduct them to arrive at accurate retained earnings figures.
The accountant will also consider any changes in the company’s net assets that are not included in profits or losses (i.e., adjustments for depreciation and other non-cash items). Once you consider all these elements, you can determine the retained earnings figure.
Retained earnings represent a critical component of a company’s overall financial health, as they indicate the profits and losses the company has retained.
You can use this figure to help assess the success or failure of prior business decisions and inform plans. It’s also a key component in calculating a company’s book value, which many use to compare the market value of a company to its book value.
Accountants must accurately calculate and track retained earnings because it provides insight into a company’s financial performance over time. Accurate calculations can help the company make informed business decisions and ensure that profits get reinvested to benefit the company.
Related: 4 Reasons Why It’s Time to Hire an Accountant for Your Small Business
How can you use retained earnings?
While retained earnings can be an excellent resource for financing growth, they can also tie up a significant amount of capital.
That’s why you must carefully consider how best to use your company’s retained earnings. The following are four common examples of how businesses might use their retained earnings.
1. Expansion
Perhaps the most common use of retained earnings is financing expansion efforts. This can include everything from opening new locations to expanding existing ones.
If you use retained earnings for expansion, you’ll need to determine a budget and stick to it. Doing so will ensure that your company uses its earnings efficiently and maintains the right balance between growth and profitability.
2. Investment
Another widespread use of retained earnings is investing in other businesses or assets. This can be risky, as you never know how an investment may turn out. That said, investing can also lead to profitable returns that you can use to grow your business further.
Related: Return on Investment (ROI) – Entrepreneur Small Business Encyclopedia
Remember to do your due diligence and understand the risks involved when investing. Ensure your investment aligns with your company’s long-term goals and core values.
3. Debt reduction
Many businesses use retained earnings to pay down debt, which can help to improve a company’s financial health and reduce its interest expenses. If you decide to reduce debt, you should prioritize which debts you’ll pay off.
For example, if you have a high-interest loan, paying that off could generate the most savings for your business. On the other hand, if you have a loan with more lenient terms and interest rates, it might make more sense to pay that one off last if you have more immediate priorities.
4. Share repurchases
Some companies use their retained earnings to repurchase shares of stock from shareholders. You might go this route for various reasons, such as increasing existing shareholders’ ownership stake or reducing the number of outstanding shares.
When repurchasing stock shares, be sure to understand the potential implications. In some cases, the repurchase may be seen as a sign of confidence and could increase the company’s common stock price and stockholder equity. But if done incorrectly, it can negatively impact existing shareholders’ equity sections and repel potential investors, harming your bottom line.
Factors that can influence a company’s retained earnings
Many factors can affect a business’s retained earnings. One is the net income or loss that the company experiences in a given period. If a company has net losses, its retained earnings will decrease. Conversely, net income will boost the company’s retained earnings.
Another factor influencing retained earnings is the distribution of dividends to shareholders. When a company pays dividends, its retained earnings are reduced by the dividend payout amount. So, if a company pays out $1,000 in dividends, its retained earnings will decrease by that amount.
Further, if the company decides to invest in new assets or purchase additional stock, this can also affect its retained earnings. Investing money into your business reduces the amount of available retained earnings while buying additional stock increases it.
Finally, companies can also choose to repurchase their own stock, which reduces retained earnings by the investment amount. By understanding these factors, your business can make informed decisions about how to manage its retained earnings.
How to read a retained earnings statement
A statement of retained earnings statement is a type of financial statement that shows the earnings the company has kept (i.e., retained) over a period of time.
The statement starts with the beginning balance of retained earnings, adds net income (or subtracts net loss), and subtracts dividends paid. This figure then gets carried over to the next period’s statement.
The purpose of the retained earnings statement is to show how much profit the company has earned and reinvested.
Here are a few steps to reading (and understanding) a retained earnings statement:
- Start by looking at the beginning balance. This gives you an idea of how much the company started with at a particular point in time.
- Look at the current period‘s net income (or net loss). This shows you how much the company has earned (or lost) in the current period.
- Look at the dividends paid during the current period. This reveals how much of the company’s earnings have been distributed to shareholders.
By subtracting the dividends paid from the net income, you can see how much profit the company has reinvested in itself. By looking at these items, you can understand a company’s performance over time and dividend policy.
Beginning retained earnings and negative retained earnings
A company’s beginning retained earnings are the first amount of retained earnings that the company has after its initial public offering (IPO). You calculate this number by subtracting a company’s total liabilities from its total assets.
If a company has negative retained earnings, its liabilities exceed its assets. In this case, the company would need to take action to improve its financial position.
This could include selling off assets, borrowing money, issuing new stock, or increasing productivity among its teams.
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Negative retained earnings don’t necessarily mean that a company is in trouble. It simply suggests that the company needs to make some changes to improve its financial health.
How to create your own retained earnings statement
If you’re a small business owner, you can create your retained earnings statement using information from your balance sheet and income statement.
Related: Use a Balance Sheet to Evaluate the Health of Your Business
Here’s how to do it:
1. Find your company’s net income for the previous period
Finding your company’s net income for the period in question is essential to understanding its retained earnings.
You can find this number by subtracting your company’s total expenses from its total revenue for the period. It tells you how much profit the company has made or lost within the established date range.
The significance of this number lies in the fact that it dictates how much money a company can reinvest into its business.
2. Find the beginning equity on your balance sheet
A company’s retained earnings statement begins with the company’s beginning equity. This number is found on the company’s balance sheet and tells you how much money the company started with at the beginning of the period.
You can also use a company’s beginning equity to calculate its net income or loss. So, if you want to know your company’s net income, simply subtract its total liabilities from its total assets.
3. Subtract any dividend payments from the previous number
Remember that your company’s retained earnings account will decrease by the amount of dividends paid out for the given accounting period. When calculating retained earnings, you’ll need to incorporate all forms of dividends; you’ll see that stock and cash dividends can impact the final number significantly.
To find your shareholders’ equity (or owner’s equity) balance, subtract the total amount of dividends paid out from the beginning equity balance. Thus, you’ll have a crystal-clear picture of how much money your company has kept within that specific period.
4. Multiply your net income by the retention rate
Your company’s retention rate is the percentage of profits reinvested into the business. Multiplying that number by your company’s net income will give you the retained earnings balance for the period.
Ready to calculate your retained earnings?
Retained earnings are a critical metric for any business. By calculating retained earnings, companies can get a snapshot of their financial health and make decisions accordingly.
The examples in this article should help you better understand how retained earnings works and what factors can influence it. Keep researching to deepen your understanding of retained earnings and position yourself for long-term success.
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