What Are Retained Earnings? Definition, Examples & Calculation
Earnings are the lifeblood of a business. They’re the basis of a business’s lifespan, and they let it continue to function. They also let it develop over time, as earnings for reinvestment are used. However, there’s a difference between earnings and retained earnings. Are you aware of the difference between the two?
If you’re building a strategy for business reinvestment, then knowing what retained earnings are is important. Luckily, we’re covering that topic in this article! Keep reading everything you need to know about retained earnings, and how to make the most of them.
Here’s What We’ll Cover:
What Are Retained Earnings?
Retained earnings are an important concept in business accounting. This concept represents the historical cumulative profit of a business. However, it requires a little math to figure out. This is because retained earnings are the accumulation of profits, minus the dividends to shareholders. The term retained earnings refers to these profits specifically, because they’ve been kept by the business.
What Are Retained Earnings Used For?
Retained earnings are used for business reinvestment. This is the best way for a business to grow, since they aren’t looking for funds from any outside sources. However, not all earnings are retained. Some are paid out in the form of dividends, as discussed prior.
Of course, businesses don’t have to pay out dividends. Dividends only apply to businesses that have shareholders. Even then, these dividend payments don’t have to be given as cash dividends. Stock dividends can also be distributed, giving shareholders additional shares. Regardless, both forms of payout still have an impact on retained earnings.
Does a Company Have to Issue Dividends on Earnings?
Not all companies offer dividends to their shareholders. Still, others offer them in the form of cash or additional stock. Most companies that pay dividends offer them at the end of the accounting period. This can be either quarterly or annually. It means that at the beginning of the current accounting period, they’ll pay dividends on the previous accounting period.
How Are Retained Earnings Calculated?
Calculating retained earnings is a simple task that most people can do themselves. It involves looking over financial statements, and using a basic accounting formula. Most great accounting software options can do this for you, but knowing the process is important. First, let’s look at the retained earnings formula:
Retained Earnings = Beginning Period Retained Earnings + Net Income (or Loss) - Cash Dividends - Stock Dividends
Pretty simple, right? However, to use this earnings formula accurately, you’ll need access to a few financial statements. First, you can find the net income of a company on the income statements. Then, you’ll need access to the last accounting period’s balance sheet. The balance sheet is where you can find the beginning period’s retained earnings.
Now, you’ll have to do a little research to find the company’s dividends information. Many companies will publish these as they’re dispersed, making it fairly simple to find them. If you can’t find them, though, you can calculate them! It’s as easy as modifying the earnings formula above. It would look something like this:
Dividends = Beginning Retained Earnings - Ending Retained Earnings + Net Income (or Loss)
Using this, let’s take a look at an example.
Retained Earnings Examples
Company A releases their balance sheet annually. We don’t know what their dividends are, so we’re going to use the balance sheet to calculate them. On the balance sheet, the company states that retained earnings in 2020 are $10,000. Earnings in 2019 were $9,000.
Then, when you look at Company A’s income statements, you find their net income. For 2020, the net income was $1,500. Let’s put these figures into our formula to find the dividend payouts.
Dividends = $9,000 - $10,000 + $1,500
Dividends = $500
Now that we have that information, we can plug it into our original earnings formula. This will tell us if the retained earnings are accurate, and if the dividend payouts are accurate as well.
Retained Earnings = $9,000 + $1,500 - $500
Retained Earnings = $10,000
This tells us that our accounting is accurate!
What Does the Retained Earnings Figure Tell Us?
Understanding the earnings retained by a company can tell you what reinvestment is possible. It can also give you an idea as to whether or not it is a stable company. Being able to retain earnings indicates that business is doing well, and that reinvestment is possible. Here are some of the ways that retained earnings can be used by a business:
- Businesses can use earnings to make dividend payments to shareholders. This is the only option that involves money leaving a business forever. It is not a form of reinvestment. Some businesses have a dividend policy that requires that they pay dividends to investors.
- It can be invested into current business operations. This would mean contributing it to operating costs. Some common operating expenses to invest in are increasing production, or hiring more employees.
- It can be used to pay off any outstanding debt, like business loans or lines of credit. Business debt payments are a common way to use earnings.
- Earnings can be used for share buybacks. This is when a company purchases shares back from shareholders, increasing the business’s stake in itself.
- Sometimes, earnings will be put towards innovation. This can mean product creation, or changes to the production process. These actions are meant to increase a business’s efficiency.
Comparing Retained Earnings to Revenue
Many people tend to associate retained earnings with revenue. This, in a way, makes sense. After all, revenue represents earnings, right? Well, not quite. Revenue is the figure at the top of the income statement. It is often called the top-line number when describing financial performance.
However, revenue doesn’t accurately represent the money that a company gets to keep and use. Revenue is all of the money that a company generates for an accounting period. This figure is listed on the income statement, but it doesn’t account for any expenses. Before revenue can be considered retained earnings, a few things have to happen.
Revenue isn’t a realistic figure of money made by a company. It is a figure that represents gross sales, prior to subtracting operating expenses and overhead costs. Retained earnings are the profit a company keeps after all of these expenses have been deducted.
So, when you look at the two individually, it can be hard to assess the financial picture for a company. It’s great if a company has high revenue, but it means nothing if that revenue doesn’t result in profits. The two figures need to be looked at together.
Retained earnings are essential to a business’s health. They represent the potential amount of money that a business can use for reinvestment. In order to grow, a business must invest in itself. If the company has high revenue but little profits, then retained earnings aren’t going to be visible. This spells disaster for a business. Understanding your accounting is crucial when you’re trying to be profitable! For more helpful articles like this, be sure to check out our resource hub! We have plenty of information available!