What Are the Three Components of Retained Earnings?
Learn the core factors influencing a business's retained earnings, revealing its financial health and reinvestment potential.
Retained earnings are a part of a company’s financial structure, appearing within the owner’s equity section of the balance sheet. They represent the cumulative portion of a business’s net profits that have not been distributed to shareholders as dividends but instead have been kept for reinvestment back into the business. These funds are used for purposes such as funding working capital, purchasing fixed assets, or paying off debt obligations, to generate future growth and enhance the company’s financial health. Understanding retained earnings offers insights into a company’s financial stability and its long-term potential.
Beginning Retained Earnings
Beginning retained earnings are the starting point for calculating a company’s retained earnings for the current accounting period. This figure is the accumulated balance of retained earnings from the end of the previous accounting period. It essentially represents the total profits a company has accumulated throughout its entire history up to that point, which have not yet been distributed to its shareholders.
This balance rolls over from one period to the next, reflecting the ongoing accumulation of past profits. For instance, the ending retained earnings balance from the previous year becomes the beginning balance for the current year. A company’s decision to retain these earnings rather than distribute them allows for internal financing of future operations and expansion.
Net Income or Net Loss
Net income, or net loss, directly impacts retained earnings by reflecting a company’s profitability over a specific accounting period. Net income is calculated by subtracting all expenses, including taxes, from a company’s total revenues. When a company generates a net income, it signifies that profits are available for either reinvestment into the business or distribution to shareholders.
A positive net income increases retained earnings, as it adds to the accumulated profits available to the company. Conversely, a net loss, which occurs when expenses exceed revenues, decreases retained earnings. This component is a direct addition to, or subtraction from, the beginning retained earnings balance, showing how current period performance affects overall accumulated earnings.
Dividends
Dividends are distributions of a company’s profits to its shareholders. These payments represent a portion of the accumulated earnings that the company decides to pay out rather than retain for reinvestment. Both cash dividends and stock dividends reduce a company’s retained earnings.
Dividends are not considered an expense in the same way that operational costs are. Instead, they are a distribution of equity, meaning they are a direct reduction of the company’s accumulated profits.
Calculating Retained Earnings
The calculation of retained earnings integrates these three components to determine the ending balance for an accounting period.
The formula is: Ending Retained Earnings = Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends.
For example, consider a company that started the year with $100,000 in retained earnings. If the company earned a net income of $50,000 during the year and paid out $15,000 in dividends to its shareholders, the calculation would be straightforward. The ending retained earnings would be $100,000 (Beginning RE) + $50,000 (Net Income) – $15,000 (Dividends), resulting in an ending balance of $135,000.
If, however, the company experienced a net loss of $20,000 instead of a net income, and still paid out $15,000 in dividends, the calculation would adjust accordingly. The ending retained earnings would then be $100,000 (Beginning RE) – $20,000 (Net Loss) – $15,000 (Dividends), resulting in an ending balance of $65,000.