When most people think of retained earnings, they are looking for retained earnings on a balance sheet when picking stocks to buy. But understanding the concept is vital for any business because it demonstrates the true profitability of an organization.
So, what is retained earning in accounting, and why should you take the time to calculate and analyze it?
Learning how to calculate retained earnings is vital for measuring the ongoing profitability of organizations, ranging from one-man startups to multinational corporations.
Here’s what you need to know about the retained earnings formula and what influences the final figure.
Before discussing how to calculate retained earnings, it’s important to know what they are.
So, what is retained earnings?
Retained earnings represent how much a business has earned after all its obligations have been met, including payouts to shareholders and taxes. It’s the true marker of profitability over the lifetime of a business.
Any earnings retained after the business has met its obligations may be used to reward shareholders or focus on expansion.
In other words, net income is the company’s bottom line profit for the year, whereas, under the retained earnings definition, this figure is the accumulation of these net income figures over time.
You may be wondering how to find retained earnings on your balance sheet. This figure will be found on a standard balance sheet under “Shareholder’s Equity” at the end of each accounting period.
The figure is calculated by taking the balance at the start of the accounting period and adding it to the net income or loss, minus any dividend payouts.
For smaller businesses, there are unlikely to be any dividend payouts.
Thankfully, working out how to calculate retained earnings is simple and requires no complex mathematics. The retained earnings equation is quite a simple one.
The retained earnings formula is:
Retained Earnings = Current Retained Earnings + Net Profit/Loss – Dividends Paid.
Many popular accounting programs automatically include this figure in quarterly reports.
If you choose to perform the calculation manually, you’ll need:
Current Retained Earnings – Look at your previous accounting report to get this figure. This is your starting number.
Net Profit/Loss – How much money did you make or lose during the last accounting period?
Dividends Paid – If you run a corporation, you’ll need to consider how much was distributed to shareholders. Thankfully, most small businesses don’t need to concern themselves with this.
But how does this work in practice? Here’s an example.
Susie starts her own cake making business and makes $10,000 in net profits during her first year. The earnings she has retained are $10,000.
In year two, her business grows, and she makes $25,000. But since her mom and best friend help, she chooses to give them a Christmas dividend of $2,000 each. What are her retained earnings for year two?
$10,000 + $25,000 - $4,000 = $31,000 in earnings retained.
In year three, Suzie’s business suffers problems due to broken equipment and increases in the cost of her ingredients. She suffers a net loss of $5,000. She still chooses to pay out $4,000 in dividends to her mom and best friend.
Earnings retained in year three would be:
$31,000 + -$5,000 - $4,000 = $22,000 in earnings retained.
With this figure being so essential, it’s important to understand what impacts the overall figure.
Net Income – A lower net income could arise from poor sales or a major expansion. The point is a lower net income figure will reduce earnings retained.
Stock Dividends – All stock dividends are paid out of the company’s bank account. Dividend investors won’t invest in companies with high retained earnings because it typically means the money isn’t going to shareholders.
Additional Paid-in Capital – This figure doesn’t boost earnings retained but may still boost it in the long term.
Depreciation – Depreciation can reduce net income, and therefore earnings retained, if a fixed asset’s cost is spread out over its useful lifespan.
Cash Dividends – Direct cash paid out as dividends to shareholders will lower earnings retained.
For most businesses, the big influencer on the final figure is net income per accounting period. Anything that reduces this will have an impact on retained earnings and vice-versa.
Calculating this figure is vital for demonstrating the long-term profitability of a business over its lifespan. A negative figure could mean a company has become uncompetitive or isn’t spending its income wisely. Negative figures in this regard are often seen as a red flag for potential bankruptcy.
Make sure your business manages to calculate retained earnings correctly by contacting the Chicago CPA firm, Porte Brown.
Our advisors can help you to manage and grow earnings retained. Get in touch today to learn more.
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