Retained earnings are the leftover profit available to your business after you’ve paid any shareholder dividends. Or, to simplify it, they are the funds that are left over after everyone who should be paid has been paid.
Here’s what you need to know about retained earnings, including how to calculate them, what you can do with them, and more.
Why are retained earnings important?
If you want your business to thrive and grow, retained earnings will be a valuable tool. Outside of an influx of cash from an outside investor, these leftover earnings provide the main funds available to improve your business rather than “just” operate it.
The reinvestment of your retained earnings can be used to fund marketing initiatives, pay down debts, hire additional staff, or any manner of tasks designed to capture new revenues, markets, and efficiencies.
Further, substantial retained earnings indicate to potential shareholders that your business is healthy and drives more income than required for day-to-day operation alone. For existing shareholders, retained earnings will make them more willing to reinvest a portion of profits back into the company rather than keep those funds for themselves.
Keep in mind that retained earnings are not…
Retained earnings can be easily confused with other types of cash. It’s sometimes easier to understand retained earnings by seeing what they’re not. For example:
- Retained earnings vs. revenue: Revenue encompasses all of the incoming cash for a business, ignoring any corresponding expenses or payouts.
- Retained earnings vs. net income: Net income (profit) of a given period — the funds left from the total revenue after paying any business-related expense (not including shareholder dividends). For further help understanding the difference between profit and net income, it may be useful to reference the retained earnings equation below.
- Retained earnings vs. dividends: Dividends reflect the payouts made to relevant shareholders from the pool of overall profit — the last funds disbursed before calculating retained earnings.
- Retained earnings vs. cash flow: which tracks the net balance of money flowing into and out of the business. (Similarly, a cash flow statement will track the influx and outflux of funds, while a retained earnings statement will exclusively focus on profits remaining within the business.)
Calculating retained earnings
Retained earnings equation
|Retained Earnings||=||Retained Earnings From the Prior Cycle||+||Net Income (or Loss)||–||Dividends (Both Cash and Stock)|
Where can you find retained earnings on a balance sheet?
On a well-kept balance sheet, the retained earnings for a business should be rather easy to find. It will regularly appear towards the bottom of the sheet, listed among the liabilities in the Shareholder Equity section of the document.
Can you have negative retained earnings?
Yes, but only if your business operates at a loss over the given period. More specifically, your business would need to net such a loss that even the retained earnings from the previous period were consumed by the revenue-to-expense gap in the current period.
Put another way, if you can pay out dividends to stakeholders, you are not experiencing negative retained earnings. Dividends can only be paid out if a positive net income or profit exists. In this situation, you would most reduce the earnings to $0 by paying out all remaining profit after expenses to the stakeholders.
What is “retained earnings related to market value”?
When tracking a business’s growth potential and long-term health, monitoring its retained earnings related to market value can be very useful. In particular, this phrase identifies a business’s stock price change corresponding to its net retained earnings in that same time frame — typically two to three years.
|Retained Earnings Related to Market Value||=||Market Value Change|
|Total Retained Earnings|
More simply, this value allows stakeholders and other interested parties to monitor how effectively the profits reinvested in the business are being used to benefit overall growth and market value. From a shareholder point of view, it’s ideal that for every $1 of retained earnings, a business will generate at least $1 in increased market value.
What could a company do with its retained earnings?
Pay off debt
It’s possible to end the preceding year with a positive net income while still holding onto debt from previous loans or credit extensions. Using your retained earnings to pay back this outstanding debt can prove a wise choice.
Put it towards company growth
If you have been considering launching a new product, expanding into a previously-untapped market, or just hiring additional staff, your retained earnings can help cover the up-front and underlying costs of these endeavors without placing undue strain on operating budgets or existing cash flow.
Improve your current operations
While maintenance costs for equipment and technology are often figured into the operating budget, plans to upgrade or update these items with more powerful or efficient alternatives typically rely on the reinvestment of retained earnings. These improvements may require up-front capital expenditures. By using funds outside of your current cash flow, you can lessen the overall impact of these expenses.
Put funds toward mergers or acquisitions
Sometimes, it makes sense for your business to join forces with outside companies, either forming partnerships or becoming a unified corporation. But combining two businesses is never painless or cheap; retained earnings can help smooth the transition
It doesn’t always make sense for your business to reinvest all of its retained earnings. Rather, if you’re experiencing cash flow problems, you might want to use these funds to build up cash reserves within your organization. Similarly, you may choose to start or supplement your existing emergency fund — especially if your market is becoming a bit more volatile or an economic downturn seems to be on the horizon.
If your business feels that its shares are undervalued in the marketplace, you can leverage your retained earnings to purchase some of the available shares from either investors or the open market. This move reduces the number of outstanding shares and will boost your average earnings per share. And typically, as earnings per share increase, so does the market value of the remaining shares in the market.
An example of retained earnings
is The Five Fists of Fred, one of the most well-known and profitable chains of Kung Fu schools in the Northern Midwest. Owned by five friends — all named Fred — the business maintains over 43 unique locations. And in 2022, the Freds had their most successful year ever, earning roughly $7.8 million in revenue and generating $2.1 million in profit. Even better, the business had carried over $900 thousand in retained earnings from 2021, leaving the chain in a rather favorable financial position.
Having poured their (literal) blood, sweat, and tears into these schools for the past decade, the Freds received dividends from their business, absorbing roughly $750 thousand of the profit for the year. So the retained earnings for the company for 2022 can be calculated as:
The Freds have plans for this nest egg. In particular, they want to set aside $500 thousand to bolster their cash reserves and emergency fund. Another $600 thousand will be used to fund facility upgrades to its existing locations. Finally, the remaining retained income will launch the long-planned Freds’ Fist Fights — an annual double-elimination mixed martial arts tournament presided over by some of the greatest action film stars from the 1980s.
What is a retained earnings statement?
A retained earnings statement is a document that outlines the retained earnings for a business over a given period. Typically, a retained earnings statement is distributed to boost confidence among investors and the market regarding your organization’s overall health and earnings potential.
Fortunately, these statements are relatively straightforward and rather easy to generate. In particular, your report should document:
- Timeframe: Typically contained within the header, the statement should clearly delineate which dates are being covered for the statement.
- Retained earnings from the prior business cycle: Since retained earnings can be cumulative year-over-year, you’ll want to document the balance of remaining profit available at the start of the current report window.
- Adjustments: Errors occur — for example, recording a miscalculated depreciation value in your reports. Any corrections that need to be made to your financials should be reflected on the retained earnings statement.
- Net income: Record the difference between your total revenue and total expenses. If the total is positive, you’ve made a profit. If negative, you’ve lost money and potentially may not have generated positive retained earnings.
- Dividends: Identify any funds that you have dispersed to shareholders.
- Retained earnings: Using the figures already provided, you can calculate the retained earnings available to the business at the close of the reported period.
- Notes: Alongside the above values, you may also want to record any additional factors influencing how these figures should be interpreted. For example, you’d want to note if new stocks were issued for the business.
This retained earnings statement should always be evaluated against the organization’s age, industry, dividend policy, and operating cycles to provide an accurate perspective on the condition of the company in question.
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