Companies have several different types of earnings, each of which provide different information about their revenues and insight into their financial health. On a company’s balance sheet—which is a key piece of information in evaluating a company’s stock value—it will report details about its expenses and earnings, including retained earnings and net income.
Net income (NI), or net earnings, is the amount of money a company has left after subtracting operating expenses from revenue. Retained earnings goes a step further, subtracting dividend payouts to shareholders.
This article will cover how to calculate and interpret retained earnings and net income, the differences between them, and why they’re important for investors who are trading stocks online.
What is Net Income?
Net income (NI) is an indication of how profitable a company is. It is a basic calculation showing the difference between its earnings and expenses, which can include labor, marketing, depreciation, interest, taxes, operational expenses, and the cost of making products.
How to Calculate Net Income
Use the following formula to calculate the net income of a company:
Net Income = Revenue – Expenses
For example, if a company makes $50,000 in revenue during an accounting period and has $30,000 in expenses, their net income is $20,000.
Understanding Net Income
Net income is often referred to as the bottom line, since it appears on the bottom line of a company’s balance sheet and is the basic calculation of a company’s profit.
NI is used to calculate earnings per share, and is one of the key figures investors use when evaluating companies. When people talk about a company being in the red or in the black, they are referring to whether the company has a positive or negative net income.
It’s important to note that net income can be manipulated through the hiding of expenses and other means. It can be hard to figure out if this is happening, but investors might want to be wary of this and look into what numbers are being used in the net income calculation.
What Are Retained Earnings?
Retained earnings (RE) may also be referred to as unappropriated profit, uncovered loss, member capital, earnings surplus, or accumulated earnings.
Profitable companies try to strike a balance between reinvesting in their business and paying out dividends to please shareholders. After a company completes dividend payouts, they retain the amount of earnings that are left, and may decide to reinvest them into the business to continue to grow, pay off loans, or pay additional dividends.
It’s useful to understand RE when looking into companies to invest in, because they show whether a company is profitable or if all of their earnings are going towards dividends. If a company’s retained earnings are positive, this means they have money available to invest and put towards growth.
On the other hand, if a company has negative retained earnings, it means they are in debt, which is generally not a good sign.
How to Calculate Retained Earnings
Use the following formula to calculate the retained earnings of a company:
Retained earnings = Beginning retained earnings + Net income or loss – Dividends paid (cash and stock)
All of this information is available on a company’s balance sheet. In order to find beginning retained earnings one will need to look at the previous period’s balance sheet.
For example, if a company starts with $8,000 in retained earnings from the previous accounting period, these are the beginning retained earnings for the calculation. If the company makes $5,000 in net income and pays out $2,000 in dividends to shareholders, the calculation would be:
$8,000 + $5,000 – $2,000 = $11,000 in retained earnings for this accounting period
Since retained earnings carry over into each new accounting period, profitable companies generally have increasing retained earnings over time, unless they decide to spend them.
Understanding Retained Earnings
The calculated retained earnings show a company’s profit after they have paid out dividends to shareholders. If the calculation shows positive retained earnings, this means the company was profitable during the specified period of time. If the retained earnings are negative, this means the company has more debt than earnings.
Companies can use this figure to help decide how much to pay out in dividends and how much they have available to reinvest.
Although negative RI isn’t ideal, investors should consider the company’s individual circumstances when evaluating the results of the calculation. There are some instances in which negative retained earnings are fairly normal and not necessarily a reason to avoid investing.
How to Assess Retained Earnings
When assessing the retained earnings of a company, the following factors should be taken into account:
• The company’s age. If a company is only a few years old, it may be normal for it to have low or even negative retained earnings, since it must make capital investments in order to build the business before it has made many sales. Older companies tend to have higher retained earnings. If a company has been around for many years and has low or negative retained earnings, this may indicate that the company is in financial trouble.
• The company’s dividend policy. Some companies don’t pay out any dividends, while others regularly pay out high dividends. This will affect their retained earnings. In general, publicly-held companies tend to pay out more dividends than privately-held companies.
• The period of time used in the calculation. Some companies are more profitable at certain times of year, such as retail businesses. If one looks at retained earnings during the holiday season or other popular times for retail, the company may save up their profits from those times in order to get through slower times. For this reason, the same company might show different retained earnings depending on what time period is used in the calculation.
• The company’s profitability. More profitable companies tend to have higher retained earnings.
What’s the Difference Between Retained Earnings and Net Income?
Although retained earnings and net income are related, they are not the same. While net income helps with understanding profit, retained earnings help with understanding both profit and growth over time.
At times, a company may have negative retained earnings but positive net income. This is what is known as an accumulated deficit. Or the opposite may occur. For example, if a company earned $60,000 in revenue and they have $40,000 in expenses, their net income is $20,000. If they then pay out $10,000 in dividends to shareholders, the retained earnings calculation would be:
$0 + $20,000 – $10,000 = $10,000 in retained earnings
If a company has a healthy net income and retained earnings, this may be a good time for them to reinvest some of their money into growing the business. In some cases, retained earnings and net income may be the same—as when a company doesn’t pay out dividends and has no retained earnings carried over from the previous period.
Why do Retained Earnings and Net Income Matter?
Investors are often interested in retained earnings and net income because they help show the long-term financial health of a company. Figures such as revenue and expenses vary with each accounting period, and they don’t give as accurate a picture of debt and opportunity for growth.
Understanding how much profit a company really has after dividend payouts and expenses can better help investors assess the risk and opportunity involved with investing in a company. Since RI carry over into each new accounting period, they show how much a company has saved, earned, and spent over time. (Another calculation used for evaluating a company’s profitability and debt is the debt-to-equity ratio, which is a measure of how much debt it takes for a company to run its business.)
Retained earnings are also useful for companies to help determine how to spend their money. If retained earnings and/or net income are low, it might be best for the company to save their money rather than reinvesting it or paying out dividends. If the numbers are high, they can consider spending it.
Net income and retained earnings are two useful calculations that can help investors assess a company’s health, and that can help a company decide what to do with their earnings. They’re a key part of a company’s overall financial picture.
The big difference between the two figures is that while net income looks at revenue minus operating expenses, retained earnings further deducts dividend payouts from NI. Both can help form an overall view of the profitability and risk of a company.
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