Understanding your company’s financial health is crucial for long-term success, and one of the most important metrics to keep an eye on is retained earnings. Whether you’re a startup founder, small business owner, accountant, or investor, learning how to calculate retained earnings is a valuable skill that can help you make informed financial decisions.
In this article, we’ll walk you through the definition of retained earnings, the formula, examples, how it’s used in business, and tips to manage it effectively.
What Are Retained Earnings?
Retained earnings represent the portion of a company’s profit that is not distributed as dividends but is retained in the business for reinvestment or to pay off debt.
In simple terms, it’s the net income left after paying out dividends to shareholders. These earnings are shown in the equity section of the balance sheet.
Why Are Retained Earnings Important?
Retained earnings are vital for several reasons:
- Growth and Expansion: Companies reinvest retained earnings into operations, marketing, R&D, or acquisitions.
- Debt Reduction: It helps reduce liabilities by paying off existing debts.
- Financial Stability: A consistently increasing retained earnings balance indicates financial health.
- Investor Confidence: It signals long-term profitability and sustainability.
Formula to Calculate Retained Earnings
The retained earnings calculation is straightforward. You can calculate it using the following formula:
Retained Earnings = Beginning Retained Earnings + Net Income – Dividends Paid
Where:
- Beginning Retained Earnings is the balance at the start of the period (from the previous year).
- Net Income is the company’s profit after taxes and expenses.
- Dividends Paid are the cash or stock dividends paid to shareholders during the period.
Step-by-Step Guide on How to Calculate Retained Earnings
Let’s break down the calculation into manageable steps:
Step 1: Identify Beginning Retained Earnings
Start with the retained earnings from the previous accounting period. This figure is typically found in the company’s balance sheet under shareholder’s equity.
Step 2: Calculate Net Income
Use the income statement to find the net income for the current period. Net income is calculated as:
Net Income = Revenue – Expenses – Taxes
Step 3: Subtract Dividends Paid
If the company issued any dividends to shareholders, subtract that amount. This can include both cash and stock dividends.
Step 4: Plug the Values into the Formula
Now, apply the formula to calculate the retained earnings.
Example of Retained Earnings Calculation
Let’s go through a practical example.
Example:
- Beginning Retained Earnings: $150,000
- Net Income for the Year: $50,000
- Dividends Paid: $10,000
Retained Earnings = 150,000 + 50,000 – 10,000
Retained Earnings = $190,000
This means the company retains $190,000 in earnings at the end of the year.
How Retained Earnings Appear on Financial Statements
Retained earnings appear on the balance sheet under the equity section. They are cumulative, meaning they represent the total earnings retained since the company’s inception, adjusted for profits and dividends over the years.
What Affects Retained Earnings?
Several factors influence retained earnings, such as:
- Profitability: Higher profits increase retained earnings.
- Dividend Policy: The more dividends paid, the less retained earnings.
- Losses: Net losses reduce retained earnings.
- Business Strategy: Some firms prefer reinvestment over high dividend payouts.
How to Use Retained Earnings Effectively
Knowing how to calculate retained earnings is just the beginning. Here’s how businesses can use it wisely:
- Reinvest in Operations: Upgrade machinery, hire staff, or improve infrastructure.
- Research & Development: Fund innovation and product development.
- Market Expansion: Enter new markets or increase marketing efforts.
- Debt Repayment: Pay off loans and reduce interest costs.
Common Mistakes in Calculating Retained Earnings
Avoid these common errors:
- Forgetting to Subtract Dividends: Always deduct both cash and stock dividends.
- Using Gross Income Instead of Net: Only net income should be included.
- Not Updating Beginning Retained Earnings: Make sure you carry forward the correct amount from the previous period.
- Ignoring Negative Retained Earnings: This is also called an accumulated deficit and should be recorded accurately.
Retained Earnings vs. Revenue vs. Profit
These terms are often confused:
- Revenue is the total income before any expenses.
- Profit (Net Income) is revenue minus all expenses.
- Retained Earnings is net income minus dividends, carried forward from previous years.
Tools to Help You Calculate Retained Earnings
If you’re not using accounting software, you can still calculate retained earnings using:
- Excel/Google Sheets: Use basic formulas for tracking.
- Accounting Software: QuickBooks, Xero, and FreshBooks automatically track retained earnings.
- Online Calculators: Many financial websites offer free retained earnings calculators.
Benefits of Monitoring Retained Earnings
Regularly calculating and analyzing retained earnings helps:
- Track business profitability trends.
- Improve financial decision-making.
- Ensure accurate financial statements.
- Assess dividend policies and reinvestment strategies.
Tips for Managing Retained Earnings
- Set Clear Financial Goals: Know whether to reinvest or distribute earnings.
- Balance Dividends with Growth: Find a middle ground that pleases shareholders and supports growth.
- Conduct Regular Reviews: Monitor retained earnings quarterly or annually.
- Consult a CPA: Professional advice can optimize your strategy.
Final Thoughts
Understanding how to calculate retained earnings is essential for anyone involved in business finances. It gives a snapshot of your company’s ability to grow and invest in itself. By mastering the retained earnings formula and regularly updating your records, you’ll have better control over your financial future.
Start tracking your retained earnings today and make smarter, more strategic financial decisions for your business.
Frequently Asked Questions (FAQs)
1. What does it mean if retained earnings are negative?
It indicates that the company has accumulated more losses or paid out more dividends than it has earned in profits.
2. Are retained earnings the same as cash?
No. Retained earnings are an accounting concept and don’t necessarily reflect actual cash in the bank.
3. Can a company have retained earnings without profits?
Only if previous years had sufficient profits carried over. Otherwise, no.
4. Are retained earnings taxed?
Not directly. They’re part of net income, which is taxed.
5. Do all companies have retained earnings?
Not necessarily. New or unprofitable companies may have zero or negative retained earnings.
6. How often should I calculate retained earnings?
Usually at the end of each fiscal period—monthly, quarterly, or annually.
7. Are dividends subtracted from retained earnings?
Yes. All dividends reduce retained earnings.
8. Where do I find retained earnings on financial statements?
In the equity section of the balance sheet.
9. Is retained earnings a liability?
No, it’s part of shareholders’ equity.
10. What affects the retained earnings amount?
Net income, dividends paid, and previous retained earnings.
11. Can retained earnings be invested?
Yes, often reinvested into the business.
12. Is retained earnings an asset?
No. It’s an equity account.
13. What is a good retained earnings balance?
That depends on the size and growth stage of the business.
14. Do retained earnings earn interest?
Not directly, unless invested in interest-bearing assets.
15. Can I use retained earnings to pay debt?
Yes, if converted to cash.
16. Are retained earnings cumulative?
Yes, they build over time.
17. How do retained earnings affect stockholder equity?
They increase total equity when profits are retained.
18. What happens to retained earnings when a business closes?
They’re distributed or written off during liquidation.
19. Do S-Corps and LLCs have retained earnings?
Yes, though handled differently for tax purposes.
20. Are retained earnings included in EBITDA?
No. EBITDA is a different measure of earnings.