Retained earnings are the funds remaining from a company's net income after all profit distributions are paid to shareholders. Retained earnings equal gross revenue minus all expenses and dividends paid in the form of either stock or cash.
It's critical for companies to track retained earnings. This information helps owners and managers make important decisions about running and growing a business, or distributing profits to shareholders. By studying retained earnings, owners can decide whether to invest more in their business, pay down debt ahead of schedule, increase future dividends, or buy back shares.
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How to calculate retained earnings
Calculating retained earnings by hand can be tricky. It involves totaling revenue and subtracting all expenses, including those related to paying company dividends. It's crucial for managers to track this figure over the year to make planning decisions and understand their financial circumstances.
Retained Earnings = Revenue - Expenses - Dividends (Cash or Stock)
These are the basic elements involved in calculating retained earnings:
- Total revenue. Start by adding up all of the company's sales over a given period.
- Expenses. Deduct expenses, such as the cost of goods sold, that are directly allocable to products sold. Subtract overhead and other fixed expenses as well.
- Dividends. Finally, deduct any amounts the company distributed to shareholders in either cash or stock during the covered period.
While this process sounds complicated, it's relatively easy with any of the best accounting software solutions. Standard accounting software features include the ability to prepare retained earnings statements for set time periods with just a few clicks.
Examples of a retained earnings calculation
Consider a manufacturing company that books $1 million in sales over the course of a year. Let's say that over the same period, the company incurred $800,000 in total expenses, including the cost of goods sold, fixed overhead and other variable expenses. This leaves $200,000 in net income. Now, let's say the company's directors decide to pay out $50,000 in cash dividends to shareholders. That leaves a total of $150,000 in retained earnings for the year.
Alternatively, imagine a consultancy that starts the month with $10,000 in retained earnings so far for the year. The company manages to generate $80,000 in gross revenue for the month and incur $85,000 in expenses – maybe management needs to invest in a new software program or improve company offices. For this period, the company's directors elect not to pay any midyear dividends. In this case, the company's retained earnings year to date (through the most recent month) would fall to $5,000.
Speaking more generally, let's say that you're looking at a company's cash flow statement. The number at the bottom of the cash flow statement will equal the company's retained earnings for the covered period if the directors don't pay out any dividends. If they do, then retained earnings will equal the total net income reflected on the cash flow statement, minus the value of any cash or stock dividends.
How do you use retained earnings?
A company's statement of retained earnings helps business owners understand how much flexibility they have when using that money.
Here are some potential uses for a company's retained earnings:
- Growing the business
- Investing through acquisition
- Distributing additional profits to shareholders
- Preserving a cash cushion for the future
- Paying down debt ahead of schedule
- Buying back company shares
- Issuing stock options for highly compensated employees
While businesses can use retained earnings for a lot of things, they also have limitations. Most notably, retained earnings don't tell company owners or managers how to grow their business.
Why retained earnings matter
Retained earnings are one of the most important things small businesses need to know about accounting. Retained earnings matter because they measure the amount of a company's net profits left over after all expenses have been accounted for, including the cost of goods sold, overhead, debt service, taxes, and shareholder distributions. Retained earnings represent the money remaining to grow a business.
Additionally, retained earnings – and how they change over time – are a good measure of whether a company's directors are distributing too much money to its owners. A company must have some cash left over after paying profit distributions. Distributing too much of a company's profit, or generating insufficient revenue, can lead to cash calls in the future, requiring company owners to pay money into the company to keep it solvent.
Retained earnings vs. revenue
A company's retained earnings equal its net income after distributing any profits in the form of dividends paid to shareholders. Revenue is the total amount of money coming into a business, before accounting for any expenses or distributing any money to shareholders.
The difference between a company's revenue and retained earnings is equal to its expenses. Items like the cost of goods sold, fixed overhead, taxes, other variable expenses and dividends paid to shareholders are deducted from its gross revenue to calculate retained earnings.
Retained earnings FAQs
Here's a look at some of the most common questions about retained earnings.
What are the limitations of retained earnings?
A retained earnings total is an important figure for businesses to measure and track, but it has its downsides. For one thing, it's usually not very predictable because a business's revenue and expenses fluctuate.
Retained earnings can be a problem because directors need to strike a balance. If they distribute too much to shareholders, that impacts cash flow, and managers may not have enough money to maneuver. In some cases, companies may need to issue cash calls, requiring shareholders to contribute money to keep the business running.
On the other hand, if companies distribute too little, the shareholders won't be happy.
Lastly, leaving money in a business and not using it – indicated by rising retained earnings year over year – isn't productive. To benefit the business, directors must invest retained earnings back into their business operations, use it to pay down company debt, or distribute it to shareholders.
What transactions affect retained earnings?
Since a company's retained earnings are based on net income, all business transactions technically affect retained earnings. But because retained earnings equal net income minus dividends paid to shareholders, dividends directly affect a company's retained earnings.
When should you look at retained earnings reports?
To glean insights from retained earnings reports, view them regularly.
At a minimum, review retained earnings annually, but a quarterly or semi-annual review is much better. Your managers can review these reports during the course of each year to see how much cash they'll have available to pay dividends.
Thankfully, retained earnings reports are typically straightforward to run. Any of the best accounting software packages can generate retained earnings reports quickly and easily.