Retained earnings help show the true worth of a company and are an important factor in a business’s accounting. After paying dividends to shareholders, the remaining money is held in reserve called the "retained earnings". These earnings can fund business expansion, the acquisition of additional assets, or a variety of ventures.
To get a full picture of this crucial financial component, this article examines what retained earnings are, how they differ from other income, how to use the retained earnings formula to calculate the total, and how they can benefit a business.
What Is Retained Income?
Retained earnings are the number of funds that are left or retained by a business after paying out all necessary dividends to shareholders.1 This money is surplus net income that companies usually hold over for future use. Understanding retained earnings in accounting can help you evaluate the actual value of a company or business: A positive amount of retained earnings will speak to the progress and success of a company. Negative earnings, on the other hand, signal there are issues that need to be resolved, likely in the form of unnecessary expenses.
How Are Retained Earnings Different from Revenue?
Revenue refers to the gross income of a company, or the amount of money made before paying expenses and other obligations (like dividends) and is shown on an income statement. Retained earnings show the precise net income earned after paying out all expenses, including dividends to shareholders. Using the retained earnings formula, a business calculates the total funds they can hold in reserve to fund current or future endeavors.
How Do Retained Earnings Differ from Profit?
Profit is the total amount of revenue or income after subtracting all expenses. Expenses can refer to operating expenses (such as the cost of electricity in a building), overhead fees, taxes, or any other payouts a business must make to continue to function. Retained earnings are the money left after expenses, plus the payment of dividends to investors or shareholders. Using the retained earnings formula, a business can calculate the actual amount of money they’ve earned after all necessary payments have gone out.
The Retained Earnings Formula
Retained earnings = beginning retained earnings + net income (or loss) – dividends2
With the help of the formula above, a business can see how much money the company has in reserve.
For example, a business could start a new month with $5,000 already in their retained earning fund from the previous months’ surplus income. This new month has earned them an additional $5,000 of net income, which they then use to pay $1,000 to their various shareholders. Utilizing the retained earnings formula, the calculation would be $5,000 + $5,000 - $1,000 = $9,000. The business would have a total of $9,000 in its retained earnings at the end of the month. When a business is profitable, this number continues to accumulate each accounting period until the company uses the funds.
What Retained Earnings Can Tell You
The retained earnings formula helps to calculate the absolute bottom line of profit for a company. It shows how much money the company has left after all expenses and dividends have been paid. This can help a business see whether its operations are profitable or not. From there, business owners can use the number to gauge their financial health and determine whether they need to make adjustments to improve their overall net income.
The fact that a business has low or negative retained earnings does not necessarily mean that it’s failing. Many factors can influence the amount of retained earnings a company has at any given time.
- Seasonal companies: If a business is most profitable at a particular time of year due to the nature of its products or services, its retained earnings will no doubt reflect that fluctuation. For example, a ski resort or a holiday-themed shop would understandably have a lower retained income at certain times of the year.
- New businesses: Start-ups commonly go through a period of very low or even negative profit loss and should not have a robust retained earnings fund. Over time, a company will build up its revenue and be in a position to begin reserving funds to grow the business.
- Public vs. Private Business: Publicly-held companies tend to have more dividends to pay out due to having a larger number of investors and shareholders. This means their retained earnings total would be on the lower side. However, privately owned businesses may only have one or two dividends to pay so can usually count on higher retained earnings.
Who Decides What to Do with Retained Earnings and Why?
Company management is typically in charge of what happens to the retained earnings that they acquire. Since management oversees the overall health of the company and its position in the regional, national, global, or niche market, they make a majority of these big picture decisions.. Executives with an eye toward the future of the business will examine how the money could be used to expand and improve the company in ways that benefit both the company itself and its shareholders.
In public companies, a shareholder’s role is to support the business financially and vote in occasional shareholder meetings. They may choose to use their ownership status to vote against management’s decisions, but unfortunately, an individual voice is less powerful when there are a large number of shareholders involved. Conversely, a shareholder in a privately-held business is one of just a few voices, so they typically have a more active role in the financial decision-making process of the company.3
Shareholders may prefer to have the surplus funds paid out to them as bonuses for investing in the business. They may also be interested in paying off any high-interest debts the business has accumulated. With the cooperation of both shareholders and management, though, the retained earnings could be used to pay any desired dividends and make further investments toward the business’s growth.
The Importance of Retained Earnings in Accounting
Similar to foundational topics like the net income formula, debt-to-equity ratio, and the break-even point equation, the retained earnings formula is one of the most essential accounting principles to have in your arsenal. The goal of any business whether large, small, new, or old is simple: They want to make a profit. To work toward that, leaders are deeply invested in finding qualified professionals who know how to accurately calculate their profits and organize their finances. Most successful businesses recognize the importance of accounting and build out their financial departments accordingly.
Shape the Financial Foundations of Business
Accounting professionals that want to advance their skills and prepare for career progression should explore their options with a Yeshiva University online Master’s in Accounting degree. The AACSB-accredited YU Sy Syms School of Business provides students with in-demand skills that catch an employer’s eye, as well as all of the essential accounting principles for today’s markets. Every course will help you build the knowledge necessary to earn your Certified Public Accountant (CPA) certification and open a multitude of career paths in the public or private sector.
- Retrieved on 28, November, 2021, from investopedia.com/terms/r/retainedearnings.asp
- Retrieved on 28, November 2021, from .indeed.com/career-advice/career-development/retained-earnings
- Retrieved on 28, November 2021, from fhnylaw.com/rights-shareholder-private-company/