How to Calculate the Retained Earnings

Retained earnings represent a concept in business finance, reflecting a company’s accumulated profits not distributed to shareholders as dividends. Understanding how to calculate this figure is important for grasping a company’s financial standing and its capacity for future growth. This article guides you through the process of calculating retained earnings, detailing its components and integration into financial reporting.

Understanding Retained Earnings

Retained earnings represent the portion of a company’s net income kept within the business rather than paid out to its owners. These accumulated profits are reinvested into the company, supporting operational and strategic initiatives. This internal funding source allows businesses to finance expansion, invest in new assets, reduce debt, or develop new products without incurring external financing costs.

Substantial retained earnings indicate a company’s financial strength and its ability to generate profits over time. It shows a company has successfully managed its operations and reinvested its earnings for long-term value creation. Companies with consistent growth in retained earnings exhibit a healthy financial trajectory and a commitment to self-funded development.

Key Components for Calculation

Calculating retained earnings requires three financial figures, each derived from different financial statements. The starting point is “beginning retained earnings,” which represents accumulated profits from all prior periods. This figure is found on the balance sheet from the previous reporting period, within the equity section. It acts as the cumulative base upon which current period changes are added or subtracted.

The second component is “net income” (or “net loss”) for the current accounting period. Net income signifies the total earnings of a company after all expenses, including taxes, have been deducted from revenues. This figure is displayed on the income statement, also known as the profit and loss statement, reflecting the company’s profitability over a specific period. A net loss would be subtracted, rather than added, in the calculation.

Finally, “dividends declared” represent the portion of profits a company’s board of directors decides to distribute to shareholders during the period. These distributions reduce the amount of earnings kept within the business. Information regarding dividends can be found on the statement of cash flows under financing activities, or on the statement of retained earnings itself.

Performing the Calculation

The calculation of retained earnings follows a formula that adjusts the prior period’s accumulated earnings for the current period’s profitability and distributions. The formula is: Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends = Ending Retained Earnings. This equation updates the cumulative earnings figure to reflect the financial activities of the current period.

Consider an example: A company began the year with $500,000 in retained earnings. During the year, it generated a net income of $150,000. The company’s board of directors decided to declare and pay $50,000 in dividends to its shareholders.

To calculate the ending retained earnings, add the net income to the beginning balance and then subtract the dividends. So, $500,000 (Beginning Retained Earnings) + $150,000 (Net Income) – $50,000 (Dividends) equals $600,000. This $600,000 represents the company’s total accumulated earnings reinvested in the business.

Integrating Retained Earnings into Financial Statements

The ending retained earnings figure appears directly on the balance sheet. On the balance sheet, retained earnings are presented within the shareholders’ equity section, which represents the owners’ residual claim on the company’s assets after liabilities are settled. This placement underscores its nature as an accumulated ownership interest derived from past profits.

The calculation of retained earnings is detailed in a dedicated financial statement called the Statement of Retained Earnings. This statement bridges the income statement and the balance sheet, illustrating the changes in retained earnings from the beginning to the end of an accounting period. It starts with the beginning balance, adds net income, and subtracts dividends, culminating in the ending retained earnings balance. This presentation ensures transparency regarding how a company’s profits are managed and allocated.