How to Calculate Retained Earnings on a Balance Sheet

Retained earnings are a fundamental concept in financial accounting, representing the cumulative profits a company has accumulated over time. They are an important indicator of a company’s financial health and its capacity for self-funded growth. Understanding how to calculate and present retained earnings is a valuable skill for anyone seeking to interpret financial statements.

Understanding Retained Earnings

Retained earnings are the portion of a company’s cumulative net income that has been kept by the business rather than being paid out to shareholders as dividends. These accumulated profits serve as a source of internally generated funds that a company can use for various purposes. For example, retained earnings can finance ongoing operations, invest in new equipment or facilities, support research and development, or be used to pay down debt.

The amount of retained earnings reflects a company’s historical profitability and its strategy for growth. A company that consistently retains a significant portion of its earnings demonstrates a commitment to reinvesting in its future. This reinvestment can lead to increased production capacity, new product development, or expansion into new markets, all of which aim to generate more earnings in the future. Retained earnings are a component of shareholder equity on the balance sheet, illustrating the owners’ claim on the company’s assets that have been financed by accumulated profits.

Identifying the Necessary Financial Information

To calculate a company’s retained earnings for the current period, specific financial data points must be gathered from its financial statements. The first piece of information needed is the beginning retained earnings balance. This figure represents the cumulative retained earnings from all prior periods and can be found on the previous period’s balance sheet, within the equity section.

The next necessary component is the net income or net loss for the current accounting period. This figure is reported on the company’s income statement. Net income increases retained earnings, while a net loss decreases them.

Finally, any dividends declared and paid to shareholders during the current period must be identified. Dividends represent a distribution of profits to owners and reduce the amount of earnings retained by the company. Information about dividends paid can be found in the statement of cash flows or on the statement of changes in equity.

The Retained Earnings Calculation

Once the necessary financial information has been gathered, calculating the ending retained earnings for the current period involves a straightforward formula. The calculation begins with the beginning retained earnings balance from the prior period. To this, the net income for the current period is added. Finally, any dividends paid to shareholders during the current period are subtracted.

The formula is expressed as: Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings. For example, consider a hypothetical company, “Green Earth Landscaping,” that had a retained earnings balance of $50,000 at the start of the year. During the year, Green Earth Landscaping generated a net income of $25,000 and paid out $5,000 in dividends to its owners.

Applying the formula, the calculation would be: $50,000 (Beginning Retained Earnings) + $25,000 (Net Income) – $5,000 (Dividends) = $70,000 (Ending Retained Earnings). This resulting $70,000 represents the amount of cumulative profits the company has retained at the end of the current period. This ending balance becomes the beginning balance for the next accounting period, illustrating the cumulative nature of retained earnings.

Presenting Retained Earnings on the Balance Sheet

The calculated retained earnings figure is presented on a company’s balance sheet, which provides a snapshot of its financial position at a specific point in time. Retained earnings are found within the “Stockholders’ Equity” or “Owners’ Equity” section of the balance sheet. This section represents the owners’ residual claim on the company’s assets after all liabilities have been satisfied.

Within the equity section, retained earnings are listed alongside other equity accounts, such as common stock and additional paid-in capital. Common stock represents the capital directly contributed by shareholders through the purchase of shares, while retained earnings represent the portion of profits reinvested in the business. The inclusion of retained earnings on the balance sheet is consistent with the fundamental accounting equation: Assets = Liabilities + Equity. As retained earnings increase, they contribute to the overall increase in a company’s equity, reflecting a stronger financial position and a greater ability to fund future endeavors without incurring additional debt.