First off, it’s important to know what exactly is meant by retained earnings (RE). Retained Earnings represent that portion of business profits which are reinvested back into the company versus given as dividends to shareholders. RE are used often as working capital, for capital expenditures, also sometimes for paying down debt—there are a host of ways in which businesses use their retained earnings. You will find RE on a balance sheet. They are reported under the section labeled shareholder’s equity, figured at the end of the accounting period.
In calculating RE, the beginning retained earnings balance gets added to net income on the balance sheet (or loss as the case may be for that reporting period) and then the dividend payouts for that period are subtracted.
Why Calculate RE
You might wonder why you need to calculate RE at all. For one, retained earnings stand as a link between both the income statement and the balance sheet. As RE are recorded in the shareholder equity section, the two statements are thus connected.
Also, it gives the business a clearer picture of what they have on hand to utilize and invest back into the company. And again, the reinvestment purposes vary—from purchasing equipment, to research and development, to real estate purchases. It is all about getting the money needed into the company to grow the company. And of course, with an eye on future expansion, this reinvestment is very important for any business.
Now, on the flip side, if investing RE back in the business seems as though it will not net a robust return, then it is more likely the company will distribute the earnings to shareholders.
Using the Retained Earnings Formula
The formula to calculate retained earnings consists of the following: RE (beginning of the accounting period) plus net income (or loss as the case may be) minus both cash and stock dividends paid out for the period.
At the end of the period, RE will be shown on the balance sheet as the income from the previous year (to include current year) minus dividends paid out. So for the next accounting period, this ending balance now moves into the beginning balance slot. Keep in mind, that the resulting number might not be on the positive side, as the current period’s loss could be more than the RE beginning balance. If there is a large dividend distribution (higher than what retained earnings are) this can also result in a negative RE.
Understanding Net Income about RE
Net income is going to have a direct impact on the RE. So if there is a deficit or loss, then this of course will directly affect the retained earnings. And by the same token, if net income increases, this will have a positive impact on RE. To put it into perspective, really whatever affects net income, will also have an impact on a company’s retained earnings. Sales revenue for instance will affect net income and therefore RE. The cost of goods sold, if this goes up or down will also influence RE.
Dividends and Retained Earnings
When dividends are paid out to shareholders, they are usually done so as cash or in the form of stocks. Either way, this can ultimately reduce a business’s RE. When cash is paid out to shareholders, then the company is experiencing a cash outflow and this is reflected accordingly. On the balance sheet then, this reduces the total amount of a company’s assets, as they no longer have this liquidity. In terms of stock payouts, a portion of the retained earnings is moved to common stock. And while in this way, the company’s balance sheet isn’t affected as far as asset size, what this does do is to decrease the value of the stock shares.
Once the given period has ended, you can calculate retained earnings on the balance sheet by taking the beginning period RE, adding net income (or loss) for that period and then subtracting the dividends that were paid.
An Example Calculation
Beginning RE: $62,500
Net Income: $10,300
Dividends paid: $3,620
The formula would thus be: 62,500 + 10,300 – 3620 = 69,180. So $69,180 is the ending balance RE.
Statement of RE
While retained earnings are recorded on the balance sheet in the equity section, you might also opt to do a separate statement of retained earnings. This would then be dedicated solely to calculating your RE for a given period and would therefore list out net income or loss, beginning balance RE, dividends paid out and then arrive at the final retained earnings for the period.
Retention ratio can also be evaluated based upon a statement of retained earnings. Retention ratio is simply the percentage of income that is kept back to grow the company. The payout ratio on the other hand represents the percentage paid to shareholders—both are crucial components of this type of financial statement. Again, investors will look at this to arrive at some conclusions about the business. If a business is not reinvesting enough back into the company this could very well hinder future growth. Not to mention, if a company is using its retained earnings insufficiently it could be a signal of issues down the road, such as that business eventually having to take on too much debt.
The reasons for generating a separate statement of retained earnings are primarily to increase investor confidence. By showing that yes, the company has a surplus that can then be invested back into the business this goes a long way toward bolstering overall feelings of confidence about the status of the company and its financial well being.
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