How Companies Get and Use Retained Earnings

Retained earnings represent a company’s cumulative net income that has not been distributed to its shareholders as dividends. This fundamental component of owner’s equity on the balance sheet reflects profits a business has generated and kept. They serve as a significant indicator of a company’s financial health, demonstrating its capacity to generate profits and its ability to fund future growth from internal sources.

What Are Retained Earnings and How They Are Calculated

Retained earnings are the accumulated profits a company has held onto over time, rather than paying them out to its owners or shareholders. Understanding how these earnings are calculated provides insight into a company’s financial decisions and performance.

The calculation of retained earnings follows a straightforward formula: Beginning Retained Earnings + Net Income – Dividends. To illustrate, imagine a company starts the year with $100,000 in retained earnings. During the year, it earns a net income of $50,000 and decides to pay out $10,000 in dividends to its shareholders. The calculation would be $100,000 (Beginning Retained Earnings) + $50,000 (Net Income) – $10,000 (Dividends) = $140,000 (Ending Retained Earnings).

“Beginning Retained Earnings” refers to the balance of accumulated profits from the end of the previous accounting period. “Net Income” represents the company’s profit for the current period, after all expenses and taxes. “Dividends” are amounts distributed to shareholders, which reduce the retained earnings balance. Retained earnings are an accounting concept reflecting accumulated profits, not a physical cash balance.

Where Retained Earnings Appear on Financial Statements

Information regarding a company’s retained earnings can be found on two primary financial statements: the Statement of Retained Earnings and the Balance Sheet. The Statement of Retained Earnings, sometimes referred to as the Statement of Changes in Equity, details the changes in this account over a specific period. This statement begins with the retained earnings balance from the start of the period, adds the net income (or subtracts a net loss) from the income statement, and then deducts any dividends paid to arrive at the ending retained earnings balance.

The ending retained earnings balance calculated on the Statement of Retained Earnings is then carried over and presented on the Balance Sheet. On the Balance Sheet, retained earnings appear as a line item within the shareholders’ equity section. This signifies that retained earnings are a form of equity, representing the cumulative profits the company has generated and retained since its inception.

Reinvesting Retained Earnings for Business Expansion

Companies utilize retained earnings to foster internal growth and enhance operational capabilities, funding initiatives without external financing or ownership dilution. One common use is funding capital expenditures, which involves purchasing new equipment, upgrading technology, or expanding existing facilities. These investments aim to improve efficiency, increase production capacity, and support future revenue generation.

Retained earnings also fund research and development (R&D) for new products or services. Companies use these funds to increase working capital, ensuring sufficient liquidity for daily operations and to manage unforeseen expenses. Beyond operational needs, retained earnings can be used to pay down existing debt obligations, which improves financial stability. Businesses might also allocate retained earnings for making acquisitions, allowing them to expand into new markets.

Distributing Retained Earnings to Shareholders

Companies distribute a portion of their retained earnings to shareholders as dividends, providing a return on investment. The decision to pay dividends rests with the company’s board of directors, considering financial health, growth prospects, and shareholder expectations.

Dividends can be paid in various forms, primarily as cash dividends or stock dividends. Cash dividends involve a direct outflow of cash from the company, which reduces both the company’s cash balance and its retained earnings on the balance sheet. Stock dividends, on the other hand, involve distributing additional shares of the company’s stock to existing shareholders. While stock dividends do not affect the company’s cash position, they still reduce retained earnings by reallocating a portion of these earnings to common stock and additional paid-in capital accounts within the equity section.

Shareholders typically receive a Form 1099-DIV to report their dividend income for tax purposes. Dividends are generally taxable to shareholders, with the tax rate depending on whether they are classified as “qualified” or “ordinary” dividends. Qualified dividends, often from U.S. corporations and held for a specified period, are taxed at lower capital gains rates, which can be 0%, 15%, or 20% depending on the shareholder’s income level. Ordinary dividends are taxed at the shareholder’s regular income tax rate, which can be significantly higher.