What Equals Retained Earnings? The Formula Explained
Understand retained earnings: what this key financial figure represents, its derivation, and its role in a company's financial health.
Retained earnings represent a company’s accumulated profits that have not been distributed to its shareholders as dividends. These earnings are an indicator of a business’s financial health and its capacity for future growth. Understanding retained earnings provides insight into how a company manages its profits and reinvests in its operations.
Understanding Retained Earnings
Retained earnings are the cumulative net income a company has kept over time, rather than paying it out to shareholders. This accounting figure is not a cash balance, but rather a portion of the owner’s equity within the business. Companies utilize these retained funds for various purposes, such as reinvesting in operations, funding expansion, paying down debt, or even for future dividend distributions.
A strong balance of retained earnings can signal consistent profitability and strategic reinvestment. Conversely, a negative balance, often referred to as an accumulated deficit, indicates that a company has incurred more losses than profits over its existence or has distributed more in dividends than it has earned.
Calculating Retained Earnings
The calculation of retained earnings involves a straightforward formula that considers the previous period’s balance, current profitability, and any distributions made to shareholders. The formula is: Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings.
Beginning Retained Earnings represents the retained earnings balance from the end of the prior accounting period. This figure serves as the starting point for the current period’s calculation. Net Income, or net loss, is the company’s profit or loss for the current reporting period, derived from the income statement. A positive net income increases retained earnings, while a net loss decreases them.
Dividends are payments made to shareholders from the company’s earnings. These distributions directly reduce the retained earnings balance. For example, if a company started with $100,000 in retained earnings, earned $50,000 in net income, and paid $10,000 in dividends, its ending retained earnings would be $140,000 ($100,000 + $50,000 – $10,000). Both cash dividends and stock dividends lead to a decrease in retained earnings.
Retained Earnings on Financial Statements
Retained earnings are prominently displayed within the shareholders’ equity section of a company’s balance sheet. This placement highlights their role as a component of the owner’s claim on the company’s assets. The ending retained earnings balance calculated from the formula is the figure that appears on the balance sheet.
Beyond the balance sheet, changes in retained earnings are detailed in a separate financial statement known as the Statement of Retained Earnings, or sometimes as the Statement of Changes in Equity. This statement serves as a bridge, connecting the income statement and the balance sheet. It reconciles the opening and closing retained earnings balances for a specific period, showing how net income increases this account and how dividends decrease it. This statement offers transparency to stakeholders about how profits are utilized, whether retained for reinvestment or distributed to shareholders.