The retained earnings formula can seem complicated. However, once you understand what retained earnings are and how they are used, the formula is simple to understand.
What Are Retained Earnings?
Simply put, retained earnings are net income that is accumulated after dividends. When a business makes a profit, much of it is distributed as dividends to shareholders.
Typically, retained earnings are used as working capital to pay for capital expenditures or pay debt obligations. When you look at a company’s balance sheet, you will find retained earnings under the shareholder’s equity section, as it is a portion of a company’s net income set aside for reinvestment into the business.
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Understanding the Retained Earnings Formula
The retained earnings formula comprises four parts.
- Beginning period retained earnings
- Net income or loss
- Cash dividends
- Stock dividends
To calculate retained earnings, take the beginning retained earnings balance and either add it to the net income or reduce it by the net loss. Next, subtract dividend payouts. The equation would look like the following.
Beginning Period Retained Earnings +
Net Income/Loss –
Cash Dividends –
Stock Dividends
= Retained Earnings
Beginning Period
Accumulated income from the prior year is recorded at the end of each accounting period as retained earnings. When a new accounting cycle begins, the retained earnings balance from the previous accounting cycle is used as the retained earning’s beginning balance. This number may be positive or negative because the current accounting cycle’s net loss could be less than the retained earning’s starting balance. Also, if any dividends are distributed over the retained earning’s balance, the retained earning balance may be negative.
Net Income and Retained Earnings
A company’s net income will understandably impact its retained earning’s balance. If a company’s net income increases, the retained earning balance may increase. The opposite is true in the event of a net income loss.
Dividends and Retained Earnings
Dividends are distributed to shareholders as cash or stock, and this can reduce the value of retained earnings for a company. The payment of cash dividends is recorded as a cash outflow and a reduction in the cash account. This reduces a company’s balance sheet and asset value because part of its liquid assets has been transferred to shareholders.
Stock dividends are different as they require no cash outflow. Instead, some of the retained earnings are reallocated to common stocks and additional paid-in capital accounts. However, the value of stocks per share is decreased, and when this happens, the company’s balance sheet stays the same.
What Purpose Is Served By Retained Earnings?
Return earnings serve as an essential link between the balance sheet and the income statement. They are recorded as shareholder’s equity, making them a connection between these two vital documents.
The purpose of retained earnings varies from business to business and situation to situation. Return earnings could be used to purchase new equipment or machines, and they can finance research and development or provide money for other vital activities used to grow the company. The goal is to reinvest retained earnings to make the company more profitable, thereby creating more profits in the future.
For most businesses, keeping shareholders happy is second only to keeping customers happy. For this reason, if a company doubts its ability to earn a decent return on investing retained earnings, it may opt to distribute these earnings as dividends to shareholders. Another option would be conducting a share buyback.
Making Your Business Profitable
Retained earnings are just one of many concepts business owners need to understand to make their organization profitable and attractive to shareholders.
Fusion CPA is a business advisory firm. We understand what it takes for your business to grow and thrive. From financial planning and advisory to tax planning to bookkeeping, we have the tools to help you keep your business moving forward. Learn more by scheduling a discovery call with us today.
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