By: First Union | Date:
The Importance of Retained Earnings for Small Businesses
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What exactly are retained earnings? RE is that which has not been paid out to shareholders. So essentially what we are looking at when it comes to retained earnings is that portion of the profit that the company keeps and in this way can use to further the business. You might think of it as a sort of savings account for the business which you can then draw upon as the need arises. You arrive at RE by subtracting the dividends paid out and the beginning retained earnings balance from net income. In this article, we look closer at why you need to understand the concept of retained earnings and why consequently, it is important to small businesses.
Understanding Retained Earnings
Retained earnings represent the profit that a business has made and that has not been paid out to shareholders. Most often a company will hold onto RE for future use—anything from expansion projects to using it as working capital when needed. Frequently businesses will generate a statement of RE which can be shown to shareholders for example as far as illustrating what type of financial position the business is in.
To calculate this number, you will need to know the previous reporting period's retained earnings (or this period's beginning balance/) along with net income as well as the amount paid out to shareholders during the accounting period in question. So let's say, for example, the beginning retained earnings are 8500.00. The profit for the period was 5000.00 and a total of 7000.00 was paid in dividends. This would mean that the retained earnings at the end of the quarter or reporting period are equal to 6500.00.
Unlike net income, RE are based upon total profit in addition to other factors. And again, this is money that has not been paid out in dividends but rather is being reinvested back into the business to help grow that business. To this end, retained earnings have the potential to increase significantly. By the same token, they can decrease—this will depend on assets, the amount of debt a company has, dividends paid, among other such factors.
You want to ensure that all of your financial records are up to date and accurate as otherwise, this will give you a RE value that doesn't coincide with where that number stands. Once you have your RE, you can make some predictions, adjust for future financial needs, and overall, make smarter choices for your business.
Locating RE Information
Often, as noted, businesses will generate a separate statement of RE. This is a fairly important financial statement to have on hand, especially if for instance you are going to apply for a business loan. The retained earnings can also be found at the bottom of the income statement and are carried over to the shareholder's equity section of the balance sheet. Keeping track of retained earnings and comparing period to period, beyond allowing you to make better decisions moving forward, also lets you see how past decisions have financially affected the firm.
Why RE Is Important
So why is this number crucial to your company's financial well-being? With all of the other financial statements, you have at your disposal why even do a retained earnings statement? First off, and perhaps most importantly, is the fact that your investors want to know how much they're getting on their investment. After all, they invested to make money. The statement of retained earnings helps paint a clearer picture.
Additionally, it's about knowing precisely what is available for reinvesting back into the company. Businesses will only sit stagnant (and likely ultimately fail/) if nothing is ever reinvested back in. That said, if you put too much back into the company and leave yourself short this could be very problematic. With a statement of RE, the information is all right there for you. If you blindly spend money on projects without understanding how much truly is available this will create a hole from which it may be impossible to get out. Think of this statement as a blueprint pinpointing what you can and cannot do moving forward.
There are numerous uses for RE that are reinvested. Among the more common:
- Expansion projects. This could take the form of physical expansion by way of real estate. Perhaps it means hiring a larger staff. Or it could also be an expansion of your product lineofferings.
- Equipment upgrades. For many, especially those in the IT sector, upgrading equipment, and software is pivotal to success. Equipment could also be of the machinery variety—so construction-related equipment along the lines of bulldozers and backhoes.
- Paying off debt. Using retained earnings to square up some of your debt and thus get ahead a bit not to mention buy yourself some breathing room is also a popular use for a company's retained earnings.
For shareholders, the higher the RE, the better. More retained earnings mean they have more equity—this is because the retained earnings represent the value of their shares. If you divide the retained earnings by the number of shareholders you arrive at the value of each share.
Beyond shareholders, the statement of RE is often asked for by creditors. If you are applying for any type of business funding, for example, a creditor can look at your retained earnings to get a better sense of how stable the company is and also by comparing such statements, see a track record of financial health.
Potential investors might also ask to see this statement. They are more apt to put money into a business that has a history of high RE versus one that repeatedly falls into the negative column here.
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