What are Retained Earnings?

Retained earnings are a crucial component of a company's financial health, representing the cumulative amount of net income that a business has earned and retained rather than distributed as dividends to shareholders. Essentially, retained earnings reflect the portion of profits that have been reinvested back into the company to support growth, pay off debt, or enhance liquidity.

Where to Find Retained Earnings

You can find your company's retained earnings on its balance sheet, typically within the equity section, alongside shareholders' equity.

Calculating Retained Earnings

The formula for calculating retained earnings is straightforward:

Beginning Retained Earnings + Profit/Loss - Dividends = Retained Earnings

Let's consider a simple example to illustrate this concept. Suppose you've just started a business, and your beginning retained earnings are $0. In you first month, your business earns a profit of $50, your retained earnings would now be $50.

• Beginning Retained Earnings = $0

• Profit/Loss = $50

• Dividends = $0

Retained Earning= $0 + $50 - $0 = $50.

The Impact of Dividends

Things can get more complex when dividends are paid out to shareholders. Imagine that you've sold common stock to raise capital, and your business is now thriving. You want to reward your shareholders with cash dividends. In this scenario, the money left over after paying dividends is retained by the business.

Using the previous example as a starting point, let's say your business earned a profit of $10,000, and paid $2,000 in dividends.

The calculation would be:

• Beginning Retained Earnings = $50

• Profit/Loss = $10,000

• Dividends = $2,000

Retained Earning= $50 + $10,000 – $2,000 = $8,050

Retained Earnings vs. Net Income

Retained earnings and net income are related but distinct concepts. While they are related, there may be instances where a business has a positive net income but a negative retained earnings figure, or vice versa.

Net income is the profit left over after subtracting operating expenses from revenue. On the other hand, retained earnings are what's left from net income after dividends are paid out and beginning retained earnings are factored in.

To illustrate this difference, let's say a business earns $50,000 in revenue and has $40,000 in expenses. The net income for that month would be $10,000. However, say you have two shareholders and you gave each of them $6,000 in dividend payouts that month. If we go back to our original equation, we can see that we’re left with a negative retained earnings figure:

Beginning Retained Earnings + Profit/Loss – Dividends = Retained Earnings

$0 + $10,000 – $12,000 = -$2,000

In conclusion, retained earnings are a vital aspect of a company's financial health, representing the profits retained within the business rather than being distributed to shareholders. By understanding how to calculate retained earnings and the differences between retained earnings and net income, business owners can make informed decisions about their company's financial direction.