Retained earnings are the funds remaining in a company’s net income after all profit distributions have been paid to shareholders. Retained earnings equals gross income less all expenses and dividends paid in the form of stocks or cash.
It is essential for businesses to track retained earnings. This information helps owners and managers make important decisions about running and growing a business or distributing profits to shareholders. By studying retained earnings, owners can decide whether to invest more in their business, pay off debt sooner than expected, increase future dividends, or buy back shares.
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How to calculate retained earnings
Calculating retained earnings manually can be tricky. This involves totaling income and subtracting all expenses, including those related to paying the company’s dividends. Tracking this number throughout the year is crucial for managers to make planning decisions and understand their financial situation.
Retained Earnings = Revenue - Expenses - Dividends (Cash or Stock)
The basic elements involved in calculating retained earnings are:
- Total income. Start by adding up all of the company’s sales over a period of time.
- Expenses. Deduct expenses, such as cost of goods sold, that are directly attributable to the products sold. Also subtract overhead and other fixed expenses.
- Dividends. Finally, deduct any amounts that the company distributed to shareholders in cash or shares during the period covered.
Although this process seems complicated, it is relatively easy with one of the best accounting software solutions. Standard accounting software features include the ability to prepare retained earnings statements for defined periods with just a few clicks.
Examples of calculating retained earnings
Take the example of a manufacturing company that achieves a turnover of one million dollars over a year. Let’s say that during the same period, the business incurred $ 800,000 in total expenses, including cost of goods sold, fixed overhead, and other variable expenses. That leaves $ 200,000 in net income. Now, let’s say the directors of the company decide to pay out $ 50,000 in cash dividends to the shareholders.
This leaves a total of $ 150,000 in retained earnings for the year.
Or, imagine a consulting firm that starts the month with $ 10,000 in retained earnings so far for the year. The company manages to generate $ 80,000 in gross revenue for the month and incur $ 85,000 in expenses – perhaps management needs to invest in new software or improve company offices. During this period, the directors of the company choose not to pay mid-year dividends.
In this case, the company’s retained earnings to date (up to the most recent month) would drop to $ 5,000.
More generally, let’s say you look at a company’s cash flow statement. The number at the bottom of the cash flow statement will equal the company’s retained earnings for the period covered if the directors do not pay any dividends. If so, retained earnings will equal the total net income reflected on the cash flow statement less the value of any cash or stock dividends.
How do you use retained earnings?
The Statement of Retained Earnings of a Business helps business owners understand the flexibility they have when using that money.
Here are some potential uses of a company’s retained earnings:
- Grow the business
- Invest by acquisition
- Distribution of additional profits to shareholders
- Preserving a cash cushion for the future
- Pay off debt sooner than expected
- Company share buyback
- Issuance of stock options for highly paid employees
While businesses can use retained earnings for a lot of things, they also have limitations. Most notably, retained earnings don’t tell the owners or managers of the business How? ‘Or’ What to grow their business.
Why retained earnings matter
Retained earnings are one of the most important things small businesses need to know about accounting. Retained earnings are important because they measure the amount of a company’s net profits that remain after all expenses are recognized, including cost of goods sold, overhead, debt service, taxes and distributions. to shareholders. Retained earnings are the money left over to grow a business.
Plus, retained earnings – and how they’ve changed over time – are a good measure of whether a business’s directors are handing out too much money to its owners. A business needs to have some cash after paying the profit distributions. Spreading too much of a business’s profit or generating insufficient income can lead to future capital calls, forcing business owners to pay the business money to keep it solvent.
Retained earnings vs turnover
A company’s retained earnings are equal to its net earnings after distribution of earnings in the form of dividends paid to shareholders. Income is the total amount of money going into a business, before recording expenses or distributing money to shareholders.
The difference between a business’s income and retained earnings is equal to its expenses. Items such as cost of goods sold, fixed overheads, taxes, other variable expenses, and dividends paid to shareholders are deducted from its gross income to calculate retained earnings.
Retained Earnings FAQ
Here’s a look at some of the most common retained earnings questions.
What are the limits on retained earnings?
Total retained earnings is an important number for businesses to measure and track, but it does have its drawbacks. On the one hand, this is usually not very predictable as a business’s income and expenses fluctuate.
Retained earnings can be a problem because administrators need to strike a balance. If they distribute too much to shareholders, it impacts cash flow and managers may not have enough money to maneuver. In some cases, companies may need to issue cash calls, forcing shareholders to pay cash to keep the business going.
On the other hand, if companies distribute too little, shareholders will not be happy.
Finally, leaving money in a business and not using it – indicated by the increase in retained earnings year over year – is unproductive. To benefit the business, directors must reinvest retained earnings in their business operations, use them to pay off corporate debt, or distribute them to shareholders.
What transactions affect retained earnings?
Since a company’s retained earnings are based on net income, all business transactions technically affect retained earnings. But since retained earnings equals net income minus dividends paid to shareholders, dividends directly affect a company’s retained earnings.
When Should You Look at Retained Earnings Reports?
To glean information from retained earnings reports, review them regularly.
At a minimum, review retained earnings annually, but a quarterly or semi-annual review is much better. Your managers can review these reports over the course of each year to see how much money they will have available to pay dividends.
Fortunately, reports on retained earnings are generally straightforward to run. Any of the best accounting software packages can generate retained earnings reports quickly and easily.