A statement of retained earnings is a relatively short financial statement showing how much a company has left after paying its shareholder. Though short, it is one that every company does need to prepare. The retained earnings statement shows the change in retained earnings for that particular reporting period. As noted, retained earnings represent the money left over after shareholders get paid, so essentially the company's profit for the period. In this article, we look at how a company goes about preparing a retained earnings statements and consequently why it is useful to do so.
Understanding Retained Earnings
When there are retained earnings—again this is after shareholders get paid their dividends, the company can reinvest this money back into the business or potentially split the profit. A company will often publish their retained earnings statement as this is invaluable information for investors and also for lenders.
So the income that the company has made and then subsequently kept versus paying out to shareholders represents retained earnings. This number can be found at the bottom of a balance sheet within the shareholders' equity section most often. It can also be published, as previously mentioned, as its reportstatement.
Retained earnings will not apply to sole proprietorships—this is solely for corporations that have shareholders. A sole proprietor can generate a statement of owner's equity.
Calculating Retained Earnings
The formula for calculating your retained earnings is relatively simple. You will add the last period's retained earnings to net income (or loss if that's the case/) and then subtract dividends paid out. So it will look like the following:
Retained Earnings = Beginning Period Retained Earnings + Net Income (or Loss/) – Cash Dividends – Stock Dividends
If there are no previous retained earnings, whatever the reason, then you would begin with zero. Your net income will be taken from a specific income statement (sometimes referred to as a profit and loss statement/). The dividends paid out—be it cash or stock—can be located on your balance sheet. Keep in mind, your final number as far as retained earnings go maybe a negative number. If the reporting period's loss is larger than the previous retained earnings, you will be left with a negative outcome.
Using Retained Earnings
Companies can opt to use retained earnings in a couple of different ways. Many will reinvest the money back into the company—this could be for expansion projects perhaps, or even if they just need it as working capital. Some other ways that companies utilize their retained earnings:
- New product line: If they are looking to expand on their current offerings, using retained earnings toward a new product line could be a smart move.
- Expansion: As mentioned, expansion is also a way to invest those retained earnings. Maybe it means hiring on staff, or potentially such an expansion project could involve building out an office space.
- Pay off debts: Debt repayment is yet another good way to utilize any retained earnings and thereby help the business get ahead a bit.
Preparing the Statement of Retained Earnings
Again, this will either be its document, or additionally, it is added to a balance sheet under the shareholder's equity section. This will generally be prepared quarterly, yearly, or both.
The statement will start with the retained earnings reported at the beginning of the period—or those from the last period. It will then go on to include any adjustments resulting from net income changes as well as listing out cash and stock dividends paid. The final balance represents the retained earnings for that reporting period. To prepare this statement you do need to have an updated income statement as well as a balance sheet.
The very first line again will be the previous retained earnings. However, if you have not yet done a retained earnings statement or for whatever reason do not have a previous statement, you will start with zero. So for example, if your previous period's retained earnings were 8500.00, then the first line reads: Beginning Retained Earnings Balance: 8500.00.
You will then refer to your income statement to get the net income—again, this could potentially be a net loss as well. So the next line, as an example, may show Net Income: 9000.00.
After figuring out how much you paid out in dividends for that period, you will subtract this from net income. If you paid no dividends, then this number would simply be zero. Such might read as follows: Dividends: 3500.00.
The number you arrive at once completing all the above steps represents the retained earnings. In the case of the above examples, the resulting retained earnings would be 14000.00.
Why Do You Need a Statement of Retained Earnings
So why exactly might you want to go ahead and prepare a retained earnings statement? For one, lenders are likely going to want to take a look at it should you require funding. This statement is a good indicator of whether or not you will be able to repay a business loan. If you have no retained earnings or are in the negative for consecutive periods, this could be a red flag for lending institutions.
Additionally, this is a good document to provide to your investors. They like to see rising share prices to determine if they are getting a return on their investment. Many investors will keep track of retained earnings over numerous reporting periods and thereby gain a clearer picture of future payments as well as share prices.
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