For startups and new entrepreneurs, the term “retained earnings” may be a bit unfamiliar. But it’s something they need to learn and get used to because it plays a key role in their business’s accounting.
With that, you probably have questions like “what is retained earnings on a balance sheet,” “how to calculate it,” “how it differs from revenue,” etc.
Learn all about them and how your business can use retained earnings in this blog.
What are Retained Earnings
Retained earnings are the sum of a company’s net income minus dividends plus the increase in retained earnings from the previous year. They are a type of equity for a company.
You can use these funds to invest in new projects, pay off debt, or buy back your own shares. Thus, you can consider a company healthy if it has high retained earnings.
Retained earnings can help you measure the financial success of your company, as it’s a direct measure of your net income.
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How to Calculate Retained Earnings
Retained earnings are the amount of money left after a company pays its expenses, dividends, and taxes. It’s the number carried over from one year to the next.
Understanding how to calculate retained earnings is key to assessing your company’s performance.
Retained Earnings Formula
Retained earnings are calculated by taking the net income plus the balance of the retained earnings account at the beginning of the fiscal year and subtracting any dividends paid to shareholders.
Retained Earnings = Beginning Retained Earnings + Net Income Profit/Loss – Dividend
You will need to find retained earnings statement on your previous year’s balance sheet. It’s under the “Shareholder’s equity” section.
Retained earnings are considered equity because these are funds that the company is holding on to, or retaining, for future use.
For example, let’s say a consultancy firm had the previous year’s retained earnings of $25,000. Their total income for the current year is $30,000, and they paid $18,000 in dividends to shareholders. Their retained earnings for this year will be:
Retained Earnings = Beginning Retained Earnings ($25,000) + Net Income Profit/Loss ($30,000) – Dividends Paid ($18,000) = $37,000
Retained Earnings vs Profits
Retained earnings are profits not distributed to your shareholders. It identifies a company’s financial health and confidence in its future prospects.
In many cases, retained profits may suggest that a business has made a positive net income, but retained earnings may indicate a net loss based on the dividends paid to shareholders.
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How are Dividends Paid?
There are two forms to pay dividends:
- Cash: It’s a cash payment made to shareholders of a company, usually in proportion to the number of shares they own. Cash dividends are often issued to pay shareholders when your profits are too low to offer a meaningful return on investment. This is a way for companies to “return” some of the money they are owed to shareholders without having to give up a significant portion of their assets.
- Stock: A stock dividend is when a company pays out a portion of its stock to shareholders. This has a direct impact on the per-share market price of a company but does not affect the cash flow.
Dividends, in any form, reduce retained earnings.
How Do Businesses Use Retained Earnings?
As established before, there are many uses for retained earnings, including:
- Buying new equipment
- Launching a new product or product line
- Buying back company shares
- Preserving cash for the future
- Paying cash or stock dividends to stakeholders
- Merger, acquisition, or partnership for improved business prospects
- Paying down debt
- Research and development
A growth-focused business may choose not to pay the dividends at all and instead reinvest its retained earnings. Stakeholders may prefer this option if they see high growth prospects and returns in the future.
Preserving cash is not always the best option if you want to grow your business. You can, however, find a balance between reinvesting, saving, and paying a small dividend to your stakeholders.
You can also use retained earnings to pay off high-interest debt. Paying off debt early can help reduce the interest you need to pay as the interest rate is usually compounded.
Leverage Retained Earnings to Track Your Financial Health!
Retained earnings are one of the most important numbers in predicting your business’s financial health. Investors evaluate a company’s retained earnings to determine if it can sustain itself and grow exponentially in the future.
You can use retained earnings to make financial projections and set aside an annual budget for growing your business. Make sure to review your retained earnings regularly. A semi-annual or quarterly review is a must for any business.
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