How Do You Calculate Retained Earnings?

Retained earnings represent the accumulated net income of a company that has not been distributed to its shareholders as dividends. It is the portion of profits a business keeps to reinvest in its operations or to strengthen its overall financial standing. This article guides the reader through the process of calculating retained earnings.

Identifying the Necessary Financial Data

Calculating retained earnings requires specific financial figures derived from a company’s financial statements. The starting point is the beginning retained earnings balance, which represents the accumulated profits from all prior periods that the company has kept. This figure is found on the prior period’s Balance Sheet, within the equity section.

The next piece of information is the net income or net loss for the current accounting period. Net income signifies the company’s profit after all operating expenses, interest, and taxes have been deducted. Conversely, a net loss indicates that expenses exceeded revenues during the period. This figure is sourced directly from the company’s Income Statement.

Finally, any dividends declared during the period are necessary for the calculation. Dividends represent the portion of a company’s profits that are paid out to its shareholders. These distributions reduce the amount of earnings retained by the business. Information on dividends declared can be located in the Statement of Retained Earnings or within the financing activities section of the Statement of Cash Flows.

The Retained Earnings Formula

The standard formula used to compute retained earnings for a given accounting period links the beginning balance with the current period’s financial performance and distributions. The formula is expressed as:

Ending Retained Earnings = Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends Declared.

Net Income, when positive, increases the retained earnings, signaling an addition of new profits to the accumulated reserves. Conversely, a Net Loss reduces the retained earnings, indicating that the business consumed more capital than it generated during the period. Dividends Declared decrease retained earnings, as they represent funds flowing out of the company to its shareholders.

Step-by-Step Calculation Example

To illustrate the calculation, consider a hypothetical company, “Alpha Corp.,” at the end of its fiscal year. Alpha Corp. reported a beginning retained earnings balance of $150,000 from the close of the previous year. For the current fiscal year, the company generated a net income of $75,000. During this period, Alpha Corp. also declared and paid $20,000 in dividends to its shareholders.

The next step involves applying these figures to the retained earnings formula. We substitute the values into the equation: Ending Retained Earnings = $150,000 (Beginning Retained Earnings) + $75,000 (Net Income) – $20,000 (Dividends Declared).

Performing the arithmetic, we first add the net income to the beginning balance: $150,000 + $75,000 = $225,000. Then, we subtract the dividends paid: $225,000 – $20,000 = $205,000. Therefore, the final calculated ending retained earnings for Alpha Corp. at the close of the current fiscal year is $205,000.

Understanding What the Calculated Figure Means

The calculated retained earnings figure represents the cumulative profits a company has accumulated since its inception, after accounting for any losses incurred and dividends distributed to shareholders. It reflects the total amount of earnings that have been reinvested in the business rather than paid out to owners. This figure is presented within the shareholders’ equity section of a company’s balance sheet.

Retained earnings signify a source of capital that originates from a company’s operational activities, distinguishing it from capital raised through external investments or borrowed funds. It is important to recognize that retained earnings is an accounting figure and does not directly equate to a specific cash balance. While derived from profitable operations, the actual cash may have been used to acquire assets, reduce debt, or fund other business activities, rather than remaining as liquid cash.