Accounting 101 - What are Retained Earnings?

What are Retained Earnings? Definition, Example and Formula

Retained earnings are the portion/section of a business's net profits that remain after dividends have been distributed to shareholders. The term "retained" indicates that these earnings are not disbursed as dividends but are kept within the company, appearing on the balance sheet.

Whenever a company incurs losses or disburses dividends, its retained earnings diminish. Conversely, when the company generates profits, its retained earnings grow. This fund acts as a reserve that management can use for reinvesting in the business, often called an "earnings surplus."

Consider retained earnings as the company's net income that remains within the business for its use, post-dividend payouts.

Retained earnings are generally reported in the shareholders' equity section of a balance sheet. It's crucial to compute retained earnings at the end of each accounting period. Moreover, companies maintain a detailed report or statement of retained earnings, which tracks the variations in retained earnings over time.

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Important Factors that Affect Retained Earnings

It's essential for business management to grasp the variables that can impact retained earnings, as these elements can lead to fluctuations. Such changes sometimes stem from shifts in revenue. 

They can also arise from distributing dividends to shareholders, capital investments, alterations in liquid assets, adjustments in financial modelling, or variations in the need for working capital.

The following are factors that might lead to an increase or decrease in total retained earnings:

  • Distribution of dividends in various forms, such as scrip, cash, stock, or property, to stakeholders and owners.
  • Variations in net revenue.
  • Corrections or adjustments to the initial balance or any inaccuracies.
  • Shifts in tax rates.
  • Modifications in overhead costs or the necessity for cash flow.
  • Changes in business strategies.
  • Adjustments in accounting principles, such as switching from Last In, First Out (LIFO) to First In, First Out (FIFO) inventory accounting methods.
  • Sale of treasury stock at a price lower than its cost.
  • Resolution of deficits due to business re-organisation.

Location of Retained Earnings in Financial Statements

Retained earnings are typically situated in the shareholders' equity section of a balance sheet. This section also presents the company's final balance, generally determined after an accounting period, offering insights into the company's financial well-being. Business accounts are traditionally categorised into three main sections:

  1. Assets
  2. Liabilities
  3. Owner's Equity

Within the shareholders' equity, the breakdown further includes:

  • Common Stock
  • Retained Earnings

While most financial statements dedicate a specific section to the calculation of retained earnings, it's not uncommon for small business owners to integrate it within their income statement.

The Role of Retained Earnings

Companies leverage retained earnings for various strategic purposes. They can enhance their production capabilities, introduce new offerings, acquire state-of-the-art equipment, expand their sales force, engage in share repurchase programs, and more. Retained earnings play a vital role in evaluating a company's financial health, as they represent the accumulated net income after distributing dividends over time. This accumulation enables a company to return value to shareholders or reinvest in its growth endeavours.

Essentially, retained earnings are the cumulative profits that a company has generated, less any dividends it has distributed. Companies can utilise these funds for numerous activities, including:

  • Distributing dividends
  • Sharing profits among business owners
  • Making payments to investors
  • Expanding operational activities, such as increasing production capacity
  • Introducing new products or services
  • Forming new partnerships
  • Settling outstanding debts or loans

How to Calculate Retained Earnings?

The formula for calculating retained earnings is straightforward and crucial for understanding a company's ability to reinvest in itself or pay dividends to shareholders. The formula is:

Retained Earnings = Beginning Retained Earnings + Net Income (or Loss) - Dividends Paid

Here's a step-by-step breakdown of the calculation:

  1. Beginning Retained Earnings: This is the retained earnings balance at the start of the accounting period. It is carried over from the end of the previous period.
  2. Net Income (or Loss): This is the profit or loss the company generated during the current accounting period. It is calculated as revenues minus expenses.
  3. Dividends Paid: This includes all dividends distributed to shareholders during the current period. They could be cash dividends, stock dividends, or property dividends.

To calculate the retained earnings at the end of the current period, you start with the beginning retained earnings, add the net income earned during the period, and then subtract any dividends paid out to shareholders.

Example Calculation

Let's assume the following for a company:

  • Beginning Retained Earnings: $20,000
  • Net Income for the period: $5,000
  • Dividends Paid: $2,000

The calculation would be:

Retained Earnings = $20,000 + $5,000 - $2,000 = $23,000

Therefore, the retained earnings at the end of the period would be $23,000. This amount will be carried forward as the beginning retained earnings for the next accounting period.

Significance of Retained Earnings for Small Businesses

With the myriad of financial documents a small business manages, one might wonder about the necessity of a retained earnings statement. Here are compelling reasons for maintaining such a statement:

  • Firstly, it's invaluable for investors. They are interested in understanding the returns on their investments, and a retained earnings statement offers a clear insight into this aspect.
  • Secondly, it informs you of the available funds for reinvestment in your business. With reinvestment, businesses may avoid the risk of stagnation. However, overly investing can also deplete cash flow, making financial modelling crucial for balancing these aspects.

A retained earnings statement provides essential data for small business owners, acting as a guide for future business activities and decisions. It outlines what is feasible and what isn't in terms of business growth and strategy.

View the retained earnings account as an internal funding source akin to a savings account for the business. This approach involves conserving funds rather than distributing them as dividends or making expenditures, allowing management the flexibility to allocate funds as needed.

For small business owners, It enables the development of the business, future dividend payments, debt settlement, and more, ensuring a solid foundation for business growth and sustainability.

Key Insights to Remember

Retained earnings are what a company has left in its piggy bank after paying out dividends. Think of it as the leftover profit that businesses can use for all sorts of things, like splurging on new equipment, brewing up some exciting products, chipping away at debts, or even sharing a bit more with shareholders through stock or cash dividends.

When a company has a healthy stash of retained earnings, it's usually a good sign—it means they're doing well financially. It's common for companies, especially those looking to grow, to skip the dividend payouts and instead pour those retained earnings back into the business. This reinvestment is their way of betting on themselves to grow even bigger and better.

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What is the difference between retained earnings and revenue?

Revenue and retained earnings play pivotal roles in assessing a company's financial health, each offering insights into different facets of its financial landscape.

Revenue, by default, appears at the top of the income statement and is often regarded as the most critical figure, reflecting the company's financial performance. 

It represents the total income earned from normal business operations within a specific period before any expenses or overhead costs are subtracted. In some sectors, this total income is referred to as gross sales, emphasising that it is a gross amount calculated before any deductions.

Retained earnings, on the other hand, are the accumulated profits that a company decides to keep or reserve for future use rather than distribute as dividends. These funds, as previously mentioned, have various potential uses within the company.

Under certain conditions, retained earnings might equate to the company's net profit, especially if the business opts not to distribute dividends in the current fiscal year or if there are no deferred tax liabilities to consider. Thus, while retained earnings are derived from the cumulative profits over time, including the current reporting year, net profit specifically denotes the earnings made during that reporting period alone.

How do you analyse retained earnings?

When analysing retained earnings, a crucial aspect to observe is the variation in the equity share amount. A reduction in retained earnings might indicate a downturn in your business's revenue and operational performance. However, it's essential to consider the context of your organisation before jumping to conclusions. In mature companies, shareholders and management may perceive limited opportunities for high returns in the market. Consequently, they might opt for distributions through stock or cash dividends.

On the flip side, an increase in retained earnings can signify:

  • The accumulation of resources
  • Efficient management practices
  • A positive market environment
  • Other elements contributing to increased revenue from core business operations
  • Undistributed cash or stock dividends
  • Reporting inaccuracies

It's important to note that while accumulation may seem beneficial, it could have long-term drawbacks. Without investing in new projects or attracting investor interest, your business's revenue might decline. Additionally, your products could become less competitive regarding quality or price, as you may need more investment to improve or offer better value than your competitors.

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What are the limitations for retained earnings?

  • Variability in Profitability: Reliance on retained earnings is uncertain due to the fluctuating nature of company profits, and negative retained earnings are possible.
  • Limited Insightfulness: Analysing retained earnings over time may not provide valuable insights, as it could only show a trend in profit retention without a more profound analysis.
  • Investor Expectations for Returns: Investors often seek information on the returns generated by retained earnings rather than just the accumulated amount, preferring higher dividends in some cases.
  • Shareholder Dissatisfaction: Over-reliance on retained earnings for funding can lead to dissatisfaction among shareholders, especially if it means sacrificing dividend payments, potentially harming the company's reputation.
  • Risk of Undercapitalisation: Accumulating excessive retained earnings can lead to undercapitalisation, necessitating a balance between earnings accumulation and dividend distribution to avoid financial planning issues.
  • Potential for Monopolistic Behaviour: Excessive reinvestment of profits can lead to a company becoming overly dominant in the market, posing a risk of monopolistic behaviour and overshadowing smaller competitors.

Are retained earnings an asset or equity?

Retained earnings are classified as equity, not as an asset. They are generally recorded in the equity section of your balance sheet. However, they can be utilised by company owners to acquire new assets, such as equipment or inventory.

How is retained earnings different from net income?

Although they may seem similar, retained earnings and net income are different. Net income is the profit that remains after all operating expenses are subtracted from total revenue. Retained earnings, however, are what remains from the net income post dividends have been paid out.

How are retained earnings different from equity?

Equity represents the overall value belonging to the company's founders, owners, stakeholders, and partners. Retained earnings are a specific part of equity, indicating the net income left after distributing dividends to investors.

How are dividends related to retained earnings?

Dividends reduce the company's retained earnings. They can be issued as stock or cash dividends. Cash dividends lead to a cash outflow, appearing as a reduction in the financial records. Stock dividends do not impact cash flow but transfer a part of retained earnings to common stock.

How Do Retained Earnings Affect Net Income?

The retained earnings of a company increase with its net income. If the company records a net income of $40,000 for a period, its retained earnings for that period will also increase by $40,000.

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