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Retained earnings (RE) are the profits a business has accumulated that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business. These funds can be used for a variety of purposes, including working capital, purchasing fixed assets, and paying down debt.
Retained earnings are an important part of any business because they provide the means to reinvest in and grow your business. Companies with healthy earnings will often try to achieve a balance between rewarding owners/shareholders while also financing business growth.
Read on to learn why retained earnings are important for every business, how to calculate retained earnings, and how these funds can be used.
Key Points
• Retained earnings are the portion of a company’s net income that remains after dividends have been paid to shareholders.
• Companies report their retained earnings on the shareholders’ equity section of the balance sheet at the end of each accounting period.
• Retained earnings can be used for a variety of purposes, including staff hiring, new product launches, share buybacks, and debt repayment.
• The formula for calculating retained earnings (RE) is: Beginning RE + Net Income/Loss – Dividends.
• Creditors and investors may look at a company’s retained earnings to gauge its stability and potential for growth.
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What Are Retained Earnings?
By definition, retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. In other words, retained earnings are the profit that a business generates after costs such as salaries or production costs have been accounted for and once any dividends have been paid out to owners or shareholders.
Retained earnings are reported on a company’s balance sheet under owner’s/shareholders’ equity, which is a measure of what a business is worth. Retained earnings can fluctuate from quarter to quarter and year to year depending on whether they are accumulating or being used.
If you run a very small business, you might not even account for retained earnings and simply consider them part of working capital. However, it can be worth generating a separate statement of retained earnings. This can be a key financial statement to have on hand, especially if you’re going to apply for a small business loan. Potential investors may also be interested in looking at your retained earnings.
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Calculating Retained Earnings
In small business accounting, the retained earnings formula starts with the beginning-of-period retained earnings amount. That is carried over from the prior period’s retained earnings figure. Net income (or net loss), located at the bottom of the income statement, is then added to the first figure. Dividends, both the cash and stock types, must be removed to arrive at the end-of-period retained earnings amount.
Here is the retained earnings formula:
RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends
At the end of each accounting period, retained earnings are reported on the shareholders’ equity section of the balance sheet. In the next accounting cycle, the retained earnings ending balance from the previous accounting period will become the retained earnings beginning balance.
It’s possible for this balance to be negative. This could happen if the current period’s net loss is greater than the retained earnings beginning balance or if a distribution of dividends exceeds the retained earnings balance.
Any factors that impact net income (such as changes in sales revenue, cost of goods sold, depreciation, and other operating expenses) will directly affect the retained earnings balance.
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How Do You Use Retained Earnings?
Retained earnings can be used for a variety of purposes. Here’s a look at some of the options.
Paying Off Debt
Many businesses get their funding through different types of small business loans. Ultimately, those obligations must be paid back, and retained earnings are often used to do that. Repaying debt early can also save on interest costs, boosting profits and future retained earnings. (Keep in mind, however, that some lenders may charge a prepayment penalty.)
Mergers and Acquisitions
Retained earnings can also be used to grow a business by funding a merger, business acquisition, or partnership that could open up the company to new opportunities.
Growth and Expansion
Retained earnings may be reinvested into the company in order to:
• Launch a new product/variant.
• Increase production capacity of the existing products.
• Hire more staff.
• Buy new equipment and machines.
• Invest in research and development.
This reinvestment into the company aims to achieve even more earnings in the future.
Share Buybacks
If a company’s owner or management does not believe it can earn a sufficient return on investment from its retained earnings, it might conduct share buybacks. This involves paying shareholders the market value per share and reabsorbing that portion of the company’s ownership.
Pros and Cons of Retained Earnings
Retained earnings have both advantages and disadvantages. Here’s a look at how they stack up.
Pros of Retained Earnings
• They are an inexpensive source of funds since (unlike loans) there are no interest payments or fees.
• There are no conditions on how you can spend the money.
• They can increase your future retained earnings if reinvested wisely.
• They can be used to repay high-interest loans as well as other short-term liabilities, including accounts payable.
Cons of Retained Earnings
• The amount of retained earnings rises and falls depending on profit trends and dividend payouts.
• Shareholders may feel cheated out of dividend income if they believe you are not using the money effectively.
• Owners and managers may decide to spend the funds simply because the money is there and potentially waste it.
• Owners and managers may make risky investments because of high retained earnings.
Are Retained Earnings a Debit or Credit?
The normal balance in the retained earnings account is a credit. This number indicates that a company has, over its lifetime, generated a profit. However, the amount of the retained earnings balance could be relatively low even for a financially healthy company, since dividends are paid out from this account. Consequently, the amount of the credit balance does not necessarily indicate the relative success of a business.
When the balance in the retained earnings account is negative, this indicates that a business has incurred losses. This can happen during the startup years of a business, when it may incur sustained losses before it has accumulated enough customers and released enough products to bring in a reasonable profit.
Retained Earnings vs Dividends vs Revenue
Retained earnings, dividends, and revenue are all important ways to measure a company’s financial health. Each, however, looks at a different component of a company’s finances.
Dividends, whether distributed in the form of cash or stock, reduce retained earnings. If a company is focused on growth, it might not pay dividends or pay very small dividends and instead use the retained earnings to invest in new equipment, research and development, marketing, and/or acquisitions to boost growth. If this is the case, the company may have high retained earnings.
A more mature company, on the other hand, may not have many options for investing surplus cash and might prefer to pay dividends. In this case, a company may have low retained earnings.
Revenue refers to the total earnings a company generates through its core operations before removing any expenses.
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The Takeaway
Retained earnings are the amount of net income a company has accumulated over time after it has paid out dividends to its shareholders. There are a number of ways a business can use retained earnings. When a company is focused on growth, it may choose to use all or a significant portion of its retained earnings to fund expansion activities. Businesses in later stages might opt to use the money to pay additional dividends.
Retained earnings can also be used to determine whether a business is truly profitable. Lenders, creditors, and investors will often look at a company’s retained earnings, along with its revenue, to gain insights into the firm’s financial performance and potential for growth.
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FAQ
What are some examples of retained earnings?
Retained earnings are the amount of net income a company has left after it has paid dividends to owners/shareholders, and it’s calculated by adding net income to retained earnings at the beginning of the account period, then subtracting dividends.
For example, if a company starts the accounting period with $20,000 of retained earnings then brings in $30,000 in net income and pays out $15,000 in dividends, this would be the calculation:
$20,000 + $30,000 – $15,000 = $35,000
In this example, the company has retained earnings of $35,000 for this accounting period.
How are retained earnings calculated?
Retained earnings (RE) can be calculated using a simple formula. The formula for calculating retained earnings is as follows:
Retained Earnings = Beginning Period RE + Net Income/Loss – Dividends Paid
Are retained earnings assets or liabilities?
Neither. Though retained earnings can be used to purchase assets, they are not considered a business asset. Retained earnings are reported on the balance sheet under the owner’s/shareholders’ equity section at the end of each accounting period.
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