Retained earnings is the amount that the business is left with after paying dividends to the shareholders. A business can either have a profit or a loss. When the company earns a profit, they can either use the surplus for further business development or pay the shareholders or both. It is up to the company to decide if they want to pay that money to the shareholder or re-invest it for growth. In a simple term, any extra profit that the company generates and is not paid to the shareholders is known as retained earnings. To completely understand retained earnings, it is important to know how to calculate retained earnings.
Table of Contents
- 1 Uses of Retained Earnings
- 2 How to Calculate Retained Earnings?
Uses of Retained Earnings
Companies usually deploy retained earnings for business development, which could be anything from expanding into a new product to a new market. Mostly the company’s use retained earnings for the following:
- To invest in the existing business, amplify the production capacity of the existing products, hire more workforce and so on.
- Distribute partially or wholly among the business owners and the shareholders in the form of dividends.
- Invest in a new product or for improving organizational facilities.
- Use it for the merger, partnership, acquisition and anything that improves the business prospect.
- Use it for the share buybacks.
- To repay any outstanding loans or debts that the business might have.
How to Calculate Retained Earnings?
Before we detail how to calculate retained earnings, you must know where to find it in the financial statements and what items affect retained earnings.
Where to Find Retained Earnings?
Retained earnings come in the balance sheet of the company under the shareholder’s equity section. A company usually prepares a balance sheet at the end of each accounting period. Therefore, retained earnings can only be known at the end of the accounting period.
Investors must know that retained earnings might not be just from the current year, and may accumulate over the past several years. One can consider retained earnings as the savings account of the company in which the company deposits the surplus from all the years.
Transactions affecting Retained Earnings
The amount for retained earnings is part of the net income. For those who are unaware, net income is the amount of profit that a company earns during a reporting period. To calculate it, one needs to subtract the cost of doing business from the revenue. Costs for the company can include operating expenses, utilities, rent, payroll, general and administrative costs, depreciation, interest on the debt, overhead cost and so on.
We call net income as the bottom line as well because it is at the end of the income statement. If a company does not pay net income in the form of a dividend to the shareholders, rather retains it back, it is known as retained earnings.
Net income directly affects the retained earnings. Therefore, any factor that impacts the net income would cause an increase or a drop in the retained earnings as well. Various factors that affect net income are – revenue or sales, Cost of Goods Sold (COGS), Operating expenses Depreciation and more.
Revenue is the money that the company generates by the sales of goods and services. Or, we can say revenue is the income of the company before deducting expenses from it. Revenue is a major factor affecting retained earnings. Any increase in revenue through sales increases profits or net income. If the net income is higher, the management can allocate more funds to the retained earnings. Similar to revenue, other factors (mentioned above) can also affect retained earnings.
Additional Paid-up Capital
Apart from the items in the income statement, balance sheet items, such as Additional Paid-up capital, may also affect retained earnings. Additional paid-up capital can indirectly increase the retained earnings in the long run.
A company can distribute dividends in the form of cash or stock. Both the forms lower the retained earnings value. A cash dividend reduces the cash balance, and thus, reduces the size of the balance sheet and the overall asset value. In the case of stock dividends, there is no cash outflow. But, a portion of retained earnings reallocates from retained earnings to common stock and additional paid-in capital accounts. A point to note is that the overall size of the balance sheet remains the same in the case of a stock dividend.
Formula to Calculate Retained Earnings
In order to calculate the retained earnings for each accounting period, we add the opening balance of retained earnings to the net income or loss. From this amount, we will subtract the dividend payouts.
Retained Earnings (RE) = Beginning balance of the RE + Net Income/Loss – Cash Dividends – Stock Dividends
Retained earnings might not always be a positive number as the company might earn a profit or lose revenue during a year. Similarly, a very large distribution of dividends to the shareholders might also be more than the retained earnings balance, resulting in a negative balance. Companies also maintain a summary report, known as the statement of retained earnings. This statement defines the changes in retained earnings for that specific period.
Let us consider an example to better understand how to calculate retained earnings.
Company A has retained earnings of $10000 at the start of the year. For the year, Company A reported a net income of $5000 and paid $3000 as Dividends.
Now, retained earnings at the end of the year will be: Beginning Balance + Net Income (or loss) – Dividends or $10000 +$5000 – $3000 = $12000.
Another Way to Calculate
In accounting, the most common balance sheet relationship is between assets, liabilities, and stockholder equity. In the balance sheet, assets of the company must be equal to the sum of the liabilities and stockholder equity.
Calculating retained earnings from the balance sheet is a two-step process;
First, subtract the liabilities from assets. The remaining balance will be stockholder equity.
Second, now look for the common stock line item on the balance sheet. Subtract the common stock from stockholder equity, what’s left will be the retained earnings.
This method assumes that the stockholder equity includes two items – common stock and retained earnings. Usually, companies with complex balance sheets have additional line items and numbers as well.1,2