How to Calculate Retained Earnings: Formula and Example

Retained earnings represent a portion of a company’s accumulated net income that has not been distributed to shareholders as dividends. Instead, these earnings are kept by the business to be reinvested or used for other corporate purposes. This financial metric offers insight into a company’s profitability and its capacity for self-financing. Understanding how to calculate retained earnings is fundamental for assessing a business’s financial health and its potential for future growth.

Understanding the Components of Retained Earnings

Calculating retained earnings requires an understanding of its three main components. The starting point for any period’s calculation is the beginning retained earnings balance, which represents the total accumulated profits that a company has held onto from all prior accounting periods.

Another component is net income, which signifies a company’s total earnings or profit after all expenses, including taxes and interest. Net income increases retained earnings, as it represents new profits the company can retain. Conversely, a net loss for the period would decrease retained earnings.

The final element involves dividends, which are payments made by a corporation to its shareholders. When dividends are declared and paid out, they reduce the amount of earnings retained by the company.

The Retained Earnings Formula

The formula for calculating ending retained earnings begins with the retained earnings from the start of that period. Net income earned during the current period is added, or a net loss is subtracted. Finally, any dividends paid to shareholders during that same period are subtracted. This calculation yields the new accumulated retained earnings balance.

Applying the Calculation

Consider GreenTech Solutions at the close of its fiscal year. At the beginning of the year, GreenTech Solutions had a retained earnings balance of $250,000. During the year, the company reported a net income of $80,000 after all expenses and taxes.

The board of directors decided to distribute $30,000 in dividends to its shareholders. To calculate the ending retained earnings for GreenTech Solutions, apply the formula: $250,000 (Beginning Retained Earnings) + $80,000 (Net Income) – $30,000 (Dividends).

This results in an ending retained earnings balance of $300,000 for GreenTech Solutions. This final amount will then become the beginning retained earnings for the next fiscal period.

Interpreting the Result

The calculated retained earnings figure provides valuable insights into a company’s financial standing. A positive and growing retained earnings balance indicates that a company has been profitable and has successfully reinvested earnings back into the business, rather than distributing all profits to shareholders. This accumulated profit can be used to fund expansion, invest in new equipment, or pay down debt, contributing to financial stability.

Conversely, a negative retained earnings balance, often called an accumulated deficit, suggests that the company has experienced cumulative losses or has paid out more in dividends than it has earned. While a negative balance can signal financial weakness, it might also occur in younger companies reinvesting heavily for growth, or due to strategic, aggressive dividend payouts.

Retained earnings are a measure of a company’s long-term profitability and its capacity for internal financing and growth.