How to Calculate Addition to Retained Earnings
Master the calculation of retained earnings changes to assess a company's true financial growth and health.
Master the calculation of retained earnings changes to assess a company's true financial growth and health.
Retained earnings represent the accumulated profits a company has chosen to keep within the business, rather than distributing them to shareholders as dividends. This financial figure offers insights into a company’s ability to reinvest in its operations, fund growth initiatives, or strengthen its financial position. Tracking changes in retained earnings provides a clear picture of a company’s profit retention policies and its financial trajectory over time.
Retained earnings are the sum of all net income a company has earned since its inception, less any dividends it has paid out to its shareholders. This accumulated profit serves as a source of internal financing, allowing a company to grow without incurring additional debt or issuing new equity. It is a component of a company’s equity, reflecting its long-term profitability and financial management.
Two primary factors influence the balance of retained earnings: net income (or net loss) and dividends. Net income, which represents a company’s profit after all operating expenses, interest, and taxes have been deducted from its revenues, increases retained earnings. Conversely, a net loss for a period will decrease the balance of retained earnings.
Dividends, which are distributions of a company’s profits to its shareholders, reduce retained earnings. These payments can take various forms, such as cash dividends or stock dividends, but their effect on the retained earnings account is always a reduction. The decision to retain earnings or distribute them as dividends is a strategic one, balancing immediate shareholder returns with future growth opportunities.
Calculating the change in retained earnings over a specific period involves a formula that incorporates the beginning balance, net income or loss, and dividends. The equation to determine the ending retained earnings balance for any given period is: Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends = Ending Retained Earnings.
The net change in retained earnings for a period is simply the Net Income earned during that period minus any Dividends paid out. For example, if a company reports a net income of $500,000 for the year and pays out $100,000 in dividends, the addition to retained earnings for that year is $400,000.
Should the net income be less than the dividends paid, or if the company experiences a net loss alongside dividend payments, the result would be a reduction in retained earnings. For instance, a net income of $75,000 with $120,000 in dividends would lead to a $45,000 reduction. This calculation provides a clear measure of how much profit a company has successfully retained from its operations after satisfying shareholder distributions.
To perform the calculation for retained earnings, specific financial statements provide the necessary figures. The balance sheet offers a snapshot of a company’s financial position at a specific point in time, including the ending balance of retained earnings under the equity section. This figure represents the cumulative amount of earnings kept in the business up to that date.
The income statement, also known as the profit and loss statement, reports a company’s financial performance over a period. This statement is where the net income (or net loss) figure is found, representing the profit generated before any distributions. The net income from the income statement is a direct input for calculating the change in retained earnings.
For a detailed reconciliation of the retained earnings account, the statement of retained earnings or the broader statement of stockholders’ equity is the most direct source. This statement explicitly details the beginning retained earnings balance, adds net income, subtracts dividends, and arrives at the ending retained earnings balance. It provides a comprehensive view of all activities that affected the retained earnings account during the reporting period.