What are Retained Earnings?
In simplest terms, retained earnings are a company's profits minus its previous dividends. The term retained means that funds were not paid to shareholders as dividends instead of being held by the corporation.
Retained earnings are reported on the balance sheet under the shareholder’s equity section at the end of each accounting period.
Retained earnings demonstrate an essential tie between the balance sheet and income statement, recorded under a shareholder’s equity. In essence, it connects the two statements.
The main objective of retained earnings is to evaluate potential activities within a corporation to forecast potential growth.
For example, suppose a corporation fails to identify a profitable return in investment from their retained earnings. In that case, they’ll redistribute the earnings among shareholders as dividends.
Here’s an article that explores retained earnings in further detail.
Examples of Retained Earnings
Although they may sound intimidating to someone unfamiliar with finance, the formula for retained earnings is straightforward.
Retained earnings are the money that rolls over into every new accounting period. So the more profitable a company is, the higher its retained earnings will be.
Imagine you own a company that earns $15,000 in revenue in one accounting period. After paying expenses and taxes, you have $10,000 left. You then pay $2,000 in dividends to shareholders, leaving $8,000. During that period, the net income was $10,000, and retained earnings were $8,000.
This article highlights another example of retained earnings and how a company can calculate theirs.
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Are Retained Earnings a Liability or Asset?
A business asset is anything that a business owns and gains benefit from, such as direct cash, intellectual property, or equipment. On the other hand, a liability is counted as a debt or money that may be owed in the future.
Retained assets are an equity and a liability. However, they can be used to purchase assets such as equipment, property, and inventory.
If you want to know more about business assets vs. liabilities, this article explains both.
Retained Earnings vs. Revenue
Retained earnings are not the same as revenue, the amount of money a business earns in an accounting period.
Revenue is linked solely to the sale of products and/or services. Therefore, retained earnings, though derived from revenue, represent a different part of a business’ financial profile.
While revenue demonstrates how much a business sells, the retained earnings show how the company keeps much net income.
Revenue is at the top of every income statement. It is the amount of money a business makes before deducting expenses such as the cost of goods sold (COGS), operating expenses, and taxes.
In other words, revenue represents a period’s earnings in their purest form.
This figure is not accurately representing how much a company’s owner takes home each month. To calculate how profitable a business is, you must also look at its net income.
This article explores revenue in further detail and how it differs from net income.
Retained Earnings vs. Net Income
Net income is the amount of money a company has after subtracting operating costs, taxes, and other expenses from its revenue.
Revenue is raw data in accounting; it shows how much money a business made in a given period before any expenses were withdrawn from the balance.
Net income is the most important figure when calculating retained earnings. While net income shows how much a business had after its routine bills and expenses, retained earnings show how those earnings accumulate over time.
By evaluating a company’s retained earnings over a year, or even just one quarter, you can gain a deeper understanding of how profitable it is in the long term.
In other words, net income is helpful when identifying immediate profit, but retained earnings illustrate sustainable financial growth.
You can read this article about retained earnings vs. net income for even more detail.
How To Calculate Retained Earnings
As with all business financial formulas, you need specific figures to calculate your retained earnings.
The retained earnings formula is as follows:
RE = Beginning RE Balance + Net Income/Loss – Dividends
To begin, you will have to add your starting balance to your net income. Your starting balance is how many retained earnings you had from the last accounting period.
This would be your net profit from your first month for new businesses.
Then, you will need your net income or loss for the current accounting period. Then, you will subtract your dividends.
It’s important to note that you need to consider negative retained earnings as well.
What Do Negative Retained Earnings Mean?
Negative retained earnings signify a loss in income over time. Although a company may still be able to demonstrate financial success, its retained earnings may decrease over time if it has too many outstanding debts or dividends.
Because retained earnings help assess long-term financial health, they can also be used as a forecasting tool for your business’s finances.
When you notice retained earnings steadily decrease, this can be a forewarning of financial loss or even bankruptcy. For example, suppose total net income falls lower than debts and dividends. In that case, a company will eventually run out of funds to cover its expenses.
This article defines negative retained earnings and how they can impact a company.
Factors That Influence Retained Earnings
Retained earnings are not solely tied to shareholders. By evaluating other business areas, you can begin to identify where net income may be affected and how your bottom line ultimately affects your RE amount.
Factor 1. Sales Costs
Revenue from sales will influence the net income, affecting earnings retained after dividends are paid. If a company profits from its sales but does not net enough income post-deductions, it can stagnate or go bankrupt over time.
Factor 2. High Operating Costs
When operating expenses exceed the gross profit of a sale, you can become trapped in a repetitive cycle. While sales may be consistent, they can ultimately provide little growth if they are repeatedly put back into sustaining the company’s office space, equipment, payroll, insurance, etc.
Factor 3. Cost of Goods Sold
Businesses must continually examine their cost of goods sold (COGS) to ensure they are not overpaying for their inventory. One of the best ways for companies to improve their retained earnings is to lower the cost to produce and sell their products or services.
Factor 4. Taxes
High tax rates can drastically cut net income, so it’s important to look for opportunities to lower liability. Ongoing, strategic financial planning should include maintaining detailed documentation to qualify for as many tax credits and deductions as possible.
How to Improve Retained Earnings
To improve how much a business has at the end of each accounting period, it is helpful to look at its historical data.
Over time, have the cost of operating and manufacturing increased? As consumer demands increase, a business’s financial obligations also rise. To improve residual income each period, a business must make both small- and large-scale changes to reduce its operating costs and deficits.
Read this article
to learn more about business deficits.
