Retained Earnings: A Comprehensive Guide to Understanding and Calculating Them
Retained earnings play a crucial role in the financial health of any business. Whether you’re running a large or small corporation, understanding retained earnings and how they impact your business can help you make informed decisions. In this article, we’ll break down retained earnings, how to calculate them, and the different elements that influence them, following the PAS (Problem, Agitation, Solution) framework.
This guide is written in an engaging, energetic tone to make complex financial terms easy to understand, even for non-financial experts. Let’s dive into it!
What Are Retained Earnings?
Problem: Many business owners struggle with understanding how retained earnings affect their company’s growth and sustainability. In the daily hustle of running a business, crucial terms like retained earnings often get overlooked.
Agitation: Without a clear grasp of this concept, business owners may misinterpret their financials, missing key insights that could lead to growth opportunities. Neglecting retained earnings can result in poor planning for future reinvestments, leading to a company stagnating rather than flourishing.
Solution: So, what exactly are retained earnings? In simple terms, retained earnings are the portion of a company’s profit that is kept, or retained, in the business after dividends have been paid to shareholders. They are like a safety net for the company, set aside for future use, whether that means reinvesting in the business, paying off debt, or cushioning against financial downturns.
Retained earnings are listed on the balance sheet under shareholder equity and represent accumulated profits or losses over time. In fact, many companies that reinvest their profits into growth initiatives or product development rely heavily on these funds.
How to Find Retained Earnings
Understanding how to find retained earnings is crucial for managing your business’s financials. Here’s the basic formula:
Retained Earnings = Beginning Retained Earnings + Net Income – Dividends Paid
Let’s break it down:
- Beginning Retained Earnings: This is the retained earnings carried over from the previous accounting period.
- Net Income: The profits your business earned during the current period, which is listed on the income statement.
- Dividends Paid: Any payments made to shareholders as a reward for their investment in your business.
For instance, imagine a company that started the year with $100,000 in retained earnings. They earned a net income of $50,000 and paid out $20,000 in dividends. The retained earnings at the end of the year would be:
Retained Earnings = $100,000 + $50,000 – $20,000 = $130,000
This is a simple example of how to solve for retained earnings.
Components of Retained Earnings
Now that we’ve covered the basics, it’s time to dive deeper into the three components of retained earnings:
1. Net Income
The first component is net income, which is crucial because it determines how much profit is available to retain. Without generating sufficient profit, the company won’t have retained earnings to reinvest or save.
Agitation: Many small business owners may overlook net income as just another figure in the accounting books. However, understanding it can directly impact their ability to reinvest or pay down debts.
Solution: Tracking net income consistently can help in better forecasting retained earnings. Tools like a retained earnings calculator can assist in automating this process, saving time and reducing errors.
2. Dividends Paid
Dividends are the portion of profit that’s distributed to shareholders. The higher the dividend payments, the lower the retained earnings. Deciding the right balance between reinvesting profits and rewarding shareholders is key to sustainable growth.
3. Adjustments or Corrections
Sometimes, companies need to adjust retained earnings due to errors in previous financial statements or changes in accounting policies. The retained earnings section of the balance sheet reflects these changes.
The Importance of Retained Earnings
Problem: Many businesses fail to recognize how retained earnings directly impact their ability to reinvest and grow.
Agitation: Companies with low or negative retained earnings may struggle to fund their own growth, forcing them to rely on external financing, which can be costly or difficult to obtain.
Solution: Retained earnings allow companies to:
- Expand: Businesses can reinvest in new projects or product development.
- Pay Off Debt: Reducing debt can improve a company’s creditworthiness and financial health.
- Withstand Market Fluctuations: A strong retained earnings balance provides a buffer during economic downturns.
For example, companies that reinvest their profits can reduce their reliance on external loans and maintain greater control over their operations. This strategy has been key for “kept companies” that have weathered economic downturns effectively.
Negative Retained Earnings and Accumulated Deficit
Problem: Not every business has positive retained earnings. In fact, negative retained earnings, also known as an accumulated deficit, can pose significant challenges.
Agitation: An accumulated deficit means that a business has consistently paid out more in dividends or incurred more losses than its profits. This can signal financial instability and scare off potential investors.
Solution: It’s essential for businesses to identify the three components of retained earnings (net income, dividends, and corrections) and work toward improving each of them. By focusing on profitability and reducing unnecessary dividend payouts, businesses can reverse negative earnings.
A famous case is the “Triple F Distributing” company, which had accumulated deficits for three consecutive years. After reevaluating their dividend payouts and focusing on product improvement, they successfully turned things around, increasing their retained earnings year-over-year.
Owner Distribution and Retained Earnings
A key factor in retained earnings is recognizing the impact of owner distribution. Owner distribution refers to the earnings paid out to business owners or shareholders.
What Type of Account is Owner Distribution?
Owner distributions are classified under equity accounts and can significantly reduce retained earnings. This happens because as the company distributes more funds to owners, it retains and reinvests less money in the business.
For example, if a company regularly distributes substantial amounts to its shareholders, it might find itself without enough retained earnings to support expansion or navigate through financial challenges.
How to Calculate Retained Earnings: A Practical Example
Let’s walk through a practical example using real numbers. Suppose a business begins the year with $200,000 in retained earnings. Throughout the year, the company earns a net income of $75,000. They decide to pay out $30,000 in dividends to shareholders.
Using the retained earnings formula:
Retained Earnings = Beginning Retained Earnings + Net Income – Dividends Paid
The calculation would be:
Retained Earnings = $200,000 + $75,000 – $30,000 = $245,000
This final number represents the retained earnings at the end of the period, demonstrating the portion of profits that the company has chosen to keep rather than distribute.
Statement of Retained Earnings Template
Businesses commonly report changes in retained earnings using a statement of retained earnings template. This document helps stakeholders understand how retained earnings have changed over time and where the business stands financially.
Here’s what a basic statement of retained earnings includes:
- Beginning Retained Earnings (carried forward from the previous period)
- Net Income (profits earned during the period)
- Dividends Paid (amount distributed to shareholders)
- Ending Retained Earnings (final balance after dividends and corrections)
This report is essential for businesses, particularly those who want to attract investors. Investors look at retained earnings as a measure of financial health and long-term viability.
FAQs about Retained Earnings
How do you compute retained earnings?
You can compute retained earnings by using the formula: Retained Earnings = Beginning Retained Earnings + Net Income – Dividends Paid.
Are retained earnings a current asset?
No, retained earnings are not a current asset. They belong to shareholders’ equity and represent accumulated profits that the company has not distributed.
What does not retained mean?
“Not retained” refers to profits or earnings that a company has distributed to shareholders or spent, rather than keeping them within the business.
What are the three components of retained earnings?
The three components are net income, dividends paid, and adjustments or corrections.
How to determine retained earnings?
You determine retained earnings by starting with the beginning balance, adding net income, and subtracting any dividends paid.
Is retained earnings a temporary account?
No, retained earnings is not a temporary account. It is a permanent account that carries forward from one period to the next.
Conclusion
Retained earnings are more than just a line item on a balance sheet—they are a powerful tool that can drive your company’s growth. By understanding how to find retained earnings, identifying their components, and making smart financial decisions regarding dividends, you can strengthen your business’s financial position.
From tracking profits to knowing when to reinvest, retained earnings provide the roadmap for sustainable growth. Keep this guide handy as you navigate your company’s financial future!
