What Is the Formula for Retained Earnings?

Retained earnings represent a fundamental aspect of a company’s financial standing, reflecting its accumulated profits that have been kept within the business rather than distributed to shareholders. Understanding this financial metric is important for assessing a company’s past performance and its capacity for future growth without relying solely on external financing. The purpose of this article is to explain the specific formula used to calculate retained earnings.

Understanding Retained Earnings

Retained earnings are the portion of a company’s cumulative net income that has not been paid out as dividends to its shareholders. They represent the profits a business has chosen to reinvest in itself. This accumulation of profits is a significant component of a company’s equity on its balance sheet.

These accumulated funds serve various purposes within a business. They can be a substantial source of internal funding for future expansion projects, such as acquiring new assets, investing in research and development, or expanding operational capacity. Additionally, retained earnings can be used to pay down existing debt obligations, which strengthens the company’s financial structure and reduces interest expenses. This internal financing mechanism allows companies to grow and improve their financial health without issuing new stock or taking on more loans.

The Retained Earnings Formula

Calculating retained earnings involves a formula that begins with the retained earnings balance from the end of the previous period. It then adjusts this amount based on the current period’s profitability and any distributions made to owners.

The standard formula used to determine the ending balance of retained earnings is:

Beginning Retained Earnings + Net Income (or – Net Loss) – Dividends = Ending Retained Earnings.

Applying the Formula

To effectively use the retained earnings formula, it is necessary to understand each of its components and how to obtain their values from a company’s financial records. The first element, “Beginning Retained Earnings,” is the balance of retained earnings reported at the close of the immediately preceding accounting period. This figure can be found on the prior period’s balance sheet.

“Net Income” or “Net Loss” is derived directly from the company’s income statement for the current accounting period. Net income represents the total revenues exceeding expenses, including income taxes, for that specific period, while a net loss indicates expenses surpassed revenues. This figure is a critical input as it directly reflects the company’s profitability during the period.

“Dividends” refer to the total amount of cash distributed to shareholders during the current period. These distributions are typically declared by the company’s board of directors and reduce the amount of profit retained within the business. Dividends are often paid quarterly, and the total for the period must be subtracted from the sum of beginning retained earnings and net income.

For example, consider a company that reported beginning retained earnings of $500,000. During that year, the company generated a net income of $150,000 and distributed $50,000 in dividends. The calculation is $500,000 (Beginning Retained Earnings) + $150,000 (Net Income) – $50,000 (Dividends). This results in an Ending Retained Earnings balance of $600,000 for the current fiscal year. This final figure will then become the beginning retained earnings for the subsequent accounting period.