How to Calculate Retained Earnings Step-by-Step
Understand how to accurately calculate a company's retained earnings to gain crucial insights into its financial standing.
Retained earnings represent the cumulative portion of a company’s net income that has been kept within the business rather than being distributed to shareholders as dividends. These accumulated profits serve a significant purpose, acting as an internal source of funding for various business activities. Companies often use retained earnings to finance expansion, repay debt, or invest in new projects and research. Understanding how these earnings are calculated is fundamental for comprehending a company’s financial standing and its capacity for future growth.
Components of Retained Earnings
Calculating retained earnings requires identifying three financial figures. The first is the beginning retained earnings balance, which is the amount of accumulated earnings carried over from the end of the previous accounting period. This figure sets the baseline for the current period’s calculation, representing the profits a company had already chosen to retain.
The second component is net income or net loss, derived from the company’s income statement. Net income reflects the company’s profitability over a specific period, calculated as total revenues minus total expenses. If a company generates a net income, it adds to the retained earnings, while a net loss reduces them.
Finally, dividends paid to shareholders constitute the third component. Dividends are distributions of a company’s profits to its owners, which can be in the form of cash or additional shares. These payments reduce the amount of earnings a company keeps, as they represent profits distributed out of the business.
The Calculation Formula
The calculation of retained earnings follows a clear formula, building upon the components identified from financial statements. Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends = Ending Retained Earnings. This equation systematically accounts for the changes in a company’s accumulated earnings over an accounting period.
To apply this formula, one begins with the retained earnings balance from the close of the prior period. The net income earned during the current period is then added to this starting amount; conversely, a net loss would be subtracted. Any dividends declared and paid to shareholders during the period are subsequently subtracted from this adjusted total. The resulting figure provides the ending retained earnings balance for the current period.
For example, if a company starts with $100,000 in retained earnings, earns a net income of $50,000, and pays $20,000 in dividends, its ending retained earnings would be $130,000 ($100,000 + $50,000 – $20,000).
Impact of Financial Activities
Financial activities directly influence retained earnings. A profitable year, with net income, increases retained earnings. Conversely, a net loss reduces them. Dividends paid to shareholders also decrease retained earnings, as these are distributions of profits.
Reporting Retained Earnings
Retained earnings are featured in a company’s financial statements, providing insight into its financial health and historical profit retention. The Statement of Retained Earnings, or often the Statement of Changes in Equity, details the movements in the retained earnings balance over a specific accounting period. This statement begins with the opening balance, adds net income, and subtracts dividends, arriving at the closing balance.
The final ending retained earnings balance is then presented as a component of owner’s equity on the balance Sheet. This placement reflects its nature as an accumulated profit that belongs to the company’s owners. The balance sheet illustrates the cumulative earnings that the business has kept for reinvestment or to strengthen its financial position at a given point in time.