How to Calculate Balance of Retained Earnings

Retained earnings represent the accumulated profits a company has kept over time rather than distributing them to shareholders as dividends. These earnings are a significant indicator of a business’s financial health and its capacity for future growth. Understanding how to calculate retained earnings is important because this figure often funds business expansion, debt reduction, or other strategic investments. It shows how much profit has been reinvested back into the company, contributing to its overall equity.

Key Components of Retained Earnings

Calculating retained earnings involves understanding three main components. The first is the beginning retained earnings, which refers to the balance of accumulated profits from the end of the previous accounting period. This figure acts as the starting point for the current period’s calculation, carrying over the cumulative earnings from prior operations.

The second component is net income or net loss for the current period. Net income signifies the company’s profit after all revenues, expenses, and taxes have been accounted for, and it generally increases retained earnings. Conversely, a net loss, which occurs when expenses exceed revenues, reduces the retained earnings balance. This crucial figure is derived directly from the company’s income statement.

The final component involves dividends, which are portions of the company’s profits distributed to its shareholders. Dividends decrease the amount of earnings retained by the company, as this cash is paid out to investors. Both cash dividends and stock dividends reduce the retained earnings balance.

The Retained Earnings Formula

The calculation of retained earnings combines these components using a specific formula. This formula allows businesses to track how much of their profit is reinvested versus distributed. It directly links the company’s profitability, as shown on the income statement, with its balance sheet, specifically within the shareholders’ equity section.

The basic retained earnings formula is: Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends = Ending Retained Earnings. Net income is added, while net losses and dividends are subtracted from the beginning balance.

This formula helps illustrate the flow of profits within a business over a specific accounting period. It shows how the company’s earnings, after accounting for operational results and shareholder distributions, contribute to its accumulated equity. The ending balance then becomes the beginning balance for the next period, creating a continuous link between financial periods.

Step-by-Step Calculation Example

To illustrate the calculation, consider a hypothetical company, “Widgets Inc.” At the start of the year, Widgets Inc. had a beginning retained earnings balance of $150,000. This figure represents the accumulated profits the company had retained from all previous periods.

During the current year, Widgets Inc. generated a net income of $75,000. This profit increases the company’s retained earnings, reflecting successful operations. However, the company also decided to distribute $20,000 in dividends to its shareholders during the same period.

Applying the formula, the calculation would be: $150,000 (Beginning Retained Earnings) + $75,000 (Net Income) – $20,000 (Dividends) = $205,000 (Ending Retained Earnings). This ending balance then carries forward as the beginning retained earnings for the next accounting cycle.