What Is Retained Earnings Made Up Of?

Retained earnings represent the cumulative net income of a company that has been retained rather than distributed to shareholders as dividends. This figure shows the portion of a business’s profits reinvested back into its operations or used to reduce debt. It measures the total earnings a company has accumulated over time, after all expenses and shareholder payouts.

Key Drivers: Net Income and Dividends

The primary elements that influence a company’s retained earnings are its net income and the dividends it pays out. Net income, the profit a company earns after all revenues and expenses are calculated, directly increases the retained earnings balance. Conversely, a net loss for a period will decrease retained earnings.

Dividends paid to shareholders have the opposite effect, reducing the retained earnings balance. Dividends are a distribution of a company’s profits to its owners, and by paying them out, the company decreases the amount of profit it keeps within the business. Both cash dividends and stock dividends reduce the value of retained earnings.

The relationship between these components can be summarized by a formula: Beginning Retained Earnings + Net Income (or Loss) – Dividends = Ending Retained Earnings. This calculation is performed at the end of each accounting period. The ending balance from one period then becomes the beginning balance for the next.

Other Influencing Factors

While net income and dividends are the most frequent and significant factors, other events can also affect retained earnings. Prior period adjustments, for instance, are corrections made to the beginning balance of retained earnings due to errors discovered in previous financial periods. These errors might include unrecorded expenses or revenues, and adjusting them ensures the financial statements accurately reflect the company’s past performance. Such adjustments are typically made directly to retained earnings to avoid distorting the current period’s profit or loss.

Changes in accounting principles can also impact retained earnings. When a company changes its accounting methods, the cumulative effect of this change may be recorded directly to the opening balance of retained earnings. This adjustment ensures comparability of financial information across different reporting periods.

Treasury stock transactions can also influence retained earnings. If a company repurchases its own shares and later reissues them at a price lower than the original repurchase cost, the difference can sometimes reduce retained earnings. However, transactions involving treasury stock cannot increase retained earnings.

Retained Earnings on the Balance Sheet

Retained earnings is a component found within the shareholders’ equity section of a company’s balance sheet. It is commonly listed as a separate line item, often labeled “Retained Earnings” or “Accumulated Earnings.” This placement indicates that retained earnings represent a portion of the company’s equity that has been earned and kept by the business, rather than being contributed by investors.

It is important to understand that retained earnings is an accounting figure and does not represent a specific cash balance. Instead, it signifies the accumulated profits that a company has chosen to reinvest in its operations, pay down debt, or save for future uses, such as funding expansion or acquiring new assets. For instance, a company might use these accumulated profits to purchase new equipment, invest in research and development, or buy back its own stock.

A positive retained earnings balance generally indicates that a company has been profitable over time and has reinvested those profits back into the business. This demonstrates financial health and a capacity for internal financing, which can contribute to growth and stability. Conversely, a negative retained earnings balance, also known as an accumulated deficit, suggests that the company has incurred cumulative losses or distributed more in dividends than it has earned over its lifetime.