How to Calculate Retained Earnings: A Step-by-Step Method
Gain clarity on a core financial metric. Learn to accurately determine a company's accumulated profits for better financial insight and decision-making.
Retained earnings represent the accumulated profits a company has kept over time, rather than distributing them to shareholders as dividends. This financial figure is a fundamental part of a company’s equity, reflecting its historical profitability and capacity for self-financing future operations or expansion. Understanding retained earnings offers insight into a company’s financial strength and its strategy for growth or shareholder returns.
Understanding the Components of Retained Earnings
Calculating retained earnings requires specific financial figures. The starting point is the beginning retained earnings balance. This figure can be found on the prior period’s balance sheet or the statement of retained earnings. It serves as the baseline from which current period adjustments are made.
The company’s net income or net loss for the current period is an important component. Net income, representing the company’s profit after all expenses and taxes, increases retained earnings. Conversely, a net loss for the period will decrease this balance. This figure is available on the company’s income statement, often referred to as the statement of operations or profit and loss statement.
Dividends declared by the company also impact retained earnings. Dividends are distributions of a company’s profits to its shareholders, which reduce the amount of earnings retained within the business. Information regarding dividends declared can be located in the statement of cash flows, the statement of retained earnings, or within the notes to the financial statements.
The Retained Earnings Formula
The calculation of retained earnings follows a straightforward formula that combines these financial components. The standard formula for calculating ending retained earnings for a period is: Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends Declared = Ending Retained Earnings. This relationship illustrates how profits are added and distributions are subtracted from the initial balance, resulting in the new accumulated earnings figure for the next accounting period.
Step-by-Step Calculation Example
To illustrate the practical application of the retained earnings formula, consider a hypothetical company, “Alpha Corp.” At the start of its fiscal year, Alpha Corp reported a beginning retained earnings balance of $150,000.
During the current fiscal year, Alpha Corp generated a net income of $75,000. This profit figure is a direct result of the company’s revenues exceeding its expenses for the period.
In the same fiscal year, Alpha Corp’s board of directors declared and paid $20,000 in dividends to its shareholders. These dividends represent a distribution of the company’s profits back to its owners.
To calculate the ending retained earnings for Alpha Corp, we apply the formula: $150,000 (Beginning Retained Earnings) + $75,000 (Net Income) – $20,000 (Dividends Declared). Performing this calculation yields an ending retained earnings balance of $205,000. This final figure represents Alpha Corp’s total accumulated profits that have not been distributed to shareholders as of the end of the current fiscal year.
Other Factors Influencing Retained Earnings
Beyond the primary components, certain other transactions and adjustments can also affect a company’s retained earnings. Prior period adjustments, for instance, involve corrections of errors discovered in financial statements from previous reporting periods. These corrections are applied directly to the beginning retained earnings balance in the current period to restate the financial position accurately.
Stock repurchases, also known as treasury stock transactions, can also influence a company’s equity structure, though their direct impact is often on a separate equity account. When a company buys back its own shares, it reduces the number of outstanding shares and can reflect a strategic use of capital that might otherwise have been available for dividends or other investments. While not a direct debit to retained earnings, this action reduces overall equity.
Changes in accounting principles can also necessitate adjustments to retained earnings. When a company adopts a new accounting standard, it may be required to make a cumulative adjustment to retained earnings to reflect the standard’s impact as if it had always been in effect. This ensures comparability and consistency in financial reporting over time.