How Retained Earnings Are Calculated
Understand the fundamental process of calculating retained earnings, revealing a company's reinvested profits and capacity for future growth.
Retained earnings represent a company’s cumulative net income that has been kept within the business rather than distributed to its shareholders. This figure offers a direct insight into how much profit a company has chosen to reinvest in its operations or hold for future needs. Understanding retained earnings is fundamental for assessing a company’s financial health and its capacity for sustained growth.
What Are Retained Earnings?
Retained earnings are the portion of a company’s profits that are not paid out as dividends to shareholders but instead are held onto by the business. They accumulate over time, representing the total historical profits a company has reinvested. This accumulation is reported on the balance sheet within the shareholder’s equity section, reflecting a part of the owners’ stake in the company.
These funds serve as a significant source of internal financing for a company. They can be used to fund various activities, such as expanding operations, investing in new equipment, supporting research and development, paying down debt, or building up a reserve for unexpected challenges. The decision to retain earnings or distribute them as dividends is a strategic one, influencing the company’s financial structure and future capabilities.
Key Financial Inputs
Calculating retained earnings requires specific financial figures that are readily available from a company’s financial statements. The first component is the beginning retained earnings, which is simply the retained earnings balance from the end of the previous accounting period. This figure can be located on the prior period’s balance sheet under the equity section.
The second input is net income or net loss for the current accounting period. Net income, also known as net profit, is derived from the income statement and represents the company’s profitability after all expenses and taxes have been accounted for. A positive net income increases retained earnings, while a net loss decreases them.
Finally, dividends declared during the period are subtracted from retained earnings. Dividends are distributions of profits to shareholders, and they reduce the amount of earnings a company retains. This includes both cash dividends and stock dividends, as both represent a reduction in the company’s accumulated earnings available for reinvestment.
Performing the Calculation
The calculation of retained earnings involves a straightforward formula that integrates the key financial inputs. The standard formula is: Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends Declared = Ending Retained Earnings. This equation captures the changes in a company’s accumulated profits over a specific accounting period.
Illustrative Example
Consider a hypothetical company, “Alpha Solutions Inc.,” at the end of its fiscal year on December 31, 2024. As of January 1, 2024, Alpha Solutions Inc. had a beginning retained earnings balance of $150,000. This figure was carried over from the previous year’s financial statements.
During the fiscal year 2024, Alpha Solutions Inc. reported a net income of $75,000, as detailed on its income statement. The company also declared and paid out $20,000 in cash dividends to its shareholders.
To calculate the ending retained earnings for December 31, 2024, we apply the formula: $150,000 (Beginning Retained Earnings) + $75,000 (Net Income) – $20,000 (Dividends) = $205,000. Therefore, Alpha Solutions Inc.’s retained earnings at the end of 2024 are $205,000. This amount represents the cumulative profits the company has kept to reinvest in its operations.