Retained earnings refers to business earnings that are kept, not disbursed. More specifically, retained earnings are the profits generated by a business that are not distributed to shareholders.
Retained earnings are generally reinvested in the business in the form of upgraded equipment, new warehouse facilities, research and development, or paying off debt. Retained earnings are much like a savings account, which is usually reserved for emergencies or large purchases.
Where Can You Find Retained Earnings?
Retained earnings are listed on a company’s balance sheet under the equity section. A balance sheet provides a quick snapshot of a company’s assets, liabilities, and equity at a specific point in time. It helps business owners and outside investors understand the health and liquidity of the business.
Retained earnings are listed under equity because they are earnings owned by the company, rather than assets that may be in the company’s possession currently but not owned outright.
A high percentage of equity as retained earnings can mean a number of things. Company leaders could be “saving up” for a large purchase, conserving funds during an economic downturn, or maybe just being fiscally conservative. Whatever the case, it’s important to know how much retained earnings account for in a company’s equity—and why.
Balance Sheet vs. Income Statement
A quick way to remember that retained earnings are found on the balance sheet is to think about the fundamental differences between the balance sheet and the income statement. Unlike the income statement, which shows performance over a set period of time, the balance sheet shows a big-picture snapshot of how your company is doing.
If you generate financial statements for last quarter, for example, your income statement will show activity taking place over the entire quarter, while the balance sheet will only show the state of your finances on the last day. At the end of every accounting period (usually a month or a quarter), you’ll carry over some information on your income statement to your balance sheet. In particular, you’ll carry net income to retained earnings.
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Retained Earnings Formula
Retained earnings are calculated by taking the beginning retained earnings of a company for a specific account period, adding in net income, and subtracting dividends for that same time period. As with our savings account, we’d take our account balance for the period, add in salary and wages, and subtract bills paid.
The retained earnings formula is:
Retained Earnings = Beginning Balance + Net Income – Dividends Paid
Let’s say ABC Company has a beginning retained earnings of $200,000. By the end of the 90-day accounting period, ABC Company has earned $75,000 in income and paid $20,000 in shareholder equity.
+ $200,000 Beginning Retained Earnings
+ $75,000 Net Income
– $20,000 Dividends Paid
= $255,000 Retained Earnings
Why Should Business Owners Calculate Retained Earnings?
It’s critical for businesses to determine retained earnings, mainly for visibility purposes. Company leaders may be interested in expanding into an international market or developing a new product. What kind of resources do they need to do that? Knowing the business’s retained earnings will help them decide if they can expand using their own funds or if they need to seek outside investment.
Investors may insist that a business either increase existing dividends or simply start paying dividends on equity. At the same time, cumulative retained earnings demonstrate that a business is generating a profit. Business owners may push back on dividend requests, as cumulative profit shows a healthy business.
There may be multiple viewpoints on whether to focus on retained earnings or dividends. However, knowing how much retained earnings a company has, how much they would increase dividend payments, and the potential impact of reinvestment will give business owners an informed perspective.
What Metrics Related to Retained Earnings Should Business Owners Use?
In addition to retained earnings, company leaders can monitor the business’ growth in profit per share and overall stock price over specific periods of time. If they see progressive increases, the company’s current state of reinvesting retained earnings is considered effective. If not, it’s time to reevaluate what’s being done with retained earnings.
Ready to take your accounting know-how to the next level? Check out our list of the 37 basic accounting terms small business owners need to know.
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