How to Compute Retained Earnings: Formula & Example
Master the calculation of retained earnings to understand a company's financial health and reinvestment capacity for future growth.
Retained earnings represent the cumulative profits a company has kept over its lifetime after distributing any earnings to shareholders. This figure offers insights into a company’s financial health, indicating its ability to generate and reinvest profits for future growth. Understanding how to calculate these earnings is valuable for assessing a business’s capacity for expansion and its historical financial performance.
Key Components of Retained Earnings
Calculating retained earnings involves understanding three main components: beginning retained earnings, net income or loss, and dividends.
The beginning retained earnings balance is the cumulative profit a company had saved from all previous accounting periods. This figure serves as the starting point for the current period’s calculation and can be found on the balance sheet.
Net income or net loss reflects a company’s profitability for the current accounting period. This amount is derived from the income statement, representing the revenue remaining after all expenses, including taxes, have been deducted. A positive net income increases retained earnings, while a net loss decreases them.
Dividends are distributions of a company’s profits to its shareholders, typically in cash or sometimes as additional stock. These payments reduce the amount of earnings a company retains, as they are paid out of profits rather than being reinvested. Information regarding dividends paid can be found in the company’s financial records.
Calculating Retained Earnings
The calculation of retained earnings involves a straightforward formula that integrates prior period components with current financial results.
The formula for calculating ending retained earnings is:
Ending Retained Earnings = Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends Paid.
To illustrate, consider a company that started its fiscal year with $150,000 in retained earnings. During the year, this company achieved a net income of $75,000. Additionally, the company distributed $25,000 in dividends to its shareholders over the same period. Applying the formula, the ending retained earnings would be calculated as $150,000 (Beginning Retained Earnings) + $75,000 (Net Income) – $25,000 (Dividends Paid), resulting in $200,000.
Understanding What Retained Earnings Represent
It is an equity account on the balance sheet, representing the portion of a company’s assets financed by accumulated profits rather than by debt or new equity contributions.
A positive and growing retained earnings balance often signifies a company’s financial strength and its historical ability to generate profits. This accumulation suggests that the business has consistently earned more than it has distributed to shareholders, allowing for internal financing of future operations or expansion. Companies often use these funds for reinvestment into the business, such as purchasing new equipment, funding research and development, or reducing debt.
Conversely, a negative retained earnings balance indicates that a company has accumulated losses over time or has distributed more in dividends than it has earned. This situation can signal financial challenges or past operational difficulties. While retained earnings are a measure of cumulative profit, they do not represent a specific cash balance; rather, they show how much profit has been reinvested into the business or used to reduce liabilities.