What Are Retained Earnings?
Retained earnings represent the cumulative profits that a company has kept for itself over time, rather than distributing to shareholders as dividends. Think of it as the company's savings account that grows or shrinks based on business performance. They are reported on the balance sheet under shareholders' equity and can be used for various purposes.
Importance of Retained Earnings
- Growth and Expansion: Companies can use retained earnings to invest in new projects or expand operations
- Financial Stability: Retained earnings provide a cushion against financial difficulties
- Shareholder Value: By reinvesting profits, companies can potentially increase their value, benefiting shareholders in the long run
The Basic Formula
The formula for calculating retained earnings is:
Beginning Retained Earnings
+ Net Income (or - Net Loss)
- Dividends Paid
= Ending Retained Earnings
Step-by-Step Calculation Process
1. Gather Necessary Financial Statements
To calculate retained earnings, you will need:
- Previous period's balance sheet
- Income statement
- Statement of retained earnings
2. Determine Beginning Retained Earnings
Find the beginning retained earnings balance from the previous accounting period. For new businesses, this would be zero.
3. Calculate Net Income
Net income is calculated by:
- Adding up all revenue
- Subtracting all expenses
- Accounting for taxes and interest
Pro Tip: Make sure to use the net income after taxes for accurate calculations.
4. Account for Dividend Payments
Subtract any dividends paid to shareholders during the period:
- Cash dividends
- Stock dividends
- Special dividends
Example Calculation
Let's look at a practical example:
| Component | Amount |
|---|---|
| Beginning Retained Earnings | $50,000 |
| Net Income | $20,000 |
| Dividends Paid | $5,000 |
| Ending Retained Earnings | $65,000 |
Common Mistakes to Avoid
- Forgetting to include all dividend types
- Using pre-tax income instead of net income
- Overlooking prior period adjustments
- Not accounting for stock splits or treasury stock transactions
Additional Considerations
Industry Standards
Different industries have varying norms for retained earnings ratios. Research your industry's standards through resources like:
- Industry benchmarks
- Trade associations
- Financial databases
Impact on Business Planning
Understanding retained earnings helps with:
- Strategic planning
- Investment decisions
- Dividend policy development
- Growth projections
Regular Monitoring
Set up a system to monitor retained earnings:
- Create monthly financial reports
- Compare trends over time
- Analyze variations from projections
- Adjust business strategies accordingly
For more detailed information on financial statements and analysis, you can refer to resources like Investopedia, the Corporate Finance Institute, or the SEC website.