Net income is a phrase that all business owners like to talk about, but there is still a large number of owners who don’t know how to calculate retained earnings or what they are.
In many cases, this figure is just as important as net income.
If you don’t know the retained earnings formula, why you need to track this metric or what its purpose is, the guide below can help.
What’s The Purpose of Retained Earnings?
Net income often doesn’t provide the full picture of a business’s finances because you may also pay out dividends to shareholders or owners of the business. Since these payments are not included in net income, you need to calculate your retained earnings.
“Retained earnings do not involve cash flow. Instead, it’s a measurement of your profit and losses since a certain date,” explains cashflowfrog.com.
This profit and loss doesn’t include accounting for the dividends that you pay out.
Comparing Reserves and Retained Profits
Earnings and reserves may seem like the same thing, but they’re different measurements of a business’s financial health. The main difference is:
- Retained earnings relate to the profits of a company over a specific period of time
- Reserves are profits or funds that you’ve set aside for a purpose
For example, you may start to build up reserves to expand your operations or to pay out dividends to shareholders. However, you either have retained earnings or do not – there’s no way to save for these earnings.
Reserves in a business can be used for anything:
Your retained earnings must be disclosed publicly in your earnings and are meant to help with financing operations, paying dividends or reinvesting. Many businesses have reserves that they do not disclose and will use to offset slow periods, leverage opportunities and more.
Calculating Retained Earnings
Learning how to calculate retained earnings is easy, but you should use either:
- Software to help prepare your statements
- An accountant to help you calculate your retained earnings
Retained Earnings: How Do Accountants Calculate?
The standard formula for calculating retained earnings is to first gather information on the following:
- Beginning equity
- Net income
- Net losses
- Dividends paid
Once you have this information, you’ll then add your equity and net income together. Next, you’ll subtract your net losses and then subtract your dividends paid out to come up with your retained earnings.
Let’s look at an example:
- Beginning equity = $100,000
- Net income = $25,000
- Net losses = $45,000
- Dividends paid = $15,000
In this case, we would add $100,000 + $25,000 = $125,000. Then, we would subtract $125,000 – $45,000 = $80,000 – $15,000 = $65,000 in retained earnings.
You can also decide to calculate your retained earnings as the total of your profits and losses minus any dividends paid out.
Accountants who work on your profit and loss statement will quickly determine this figure and provide you with insight into how dividend payments will impact your operations. An accountant can also look outside of the formula to help you understand how company changes are driving your business, such as how dividends may have been better used for other purposes.
What Are Some Uses for Retained Earnings?
Retained earnings are capital that you can use to your company’s advantage if you wish. While there are many ways that you can use this resource, the most common include:
- Expansion is one of the ways that large businesses use these earnings. You can use the funds to develop new products or even grow existing offices.
- Investment in either other businesses or equipment is an option, but it does come with risks. If you invest the funds properly, it can lead to higher returns in the future. The key to success is using your due diligence to invest your earnings properly.
- Reduce debt with your earnings and lower your business risks. Many businesses will use their retained earnings to pay off any high-interest debts that they have, which will work to improve debt ratios and allow a business to withstand slow periods with greater ease.
- Repurchase shares in the business, allowing your business to reduce outstanding shares. However, working with an accountant to understand the ramifications of this decision is highly recommended.
Businesses must decide what to do with their retained earnings because if the funds are used properly, it can lead to greater revenue, lower debt and expansion into new markets.
Retained earnings provide greater insight into your true profits because it allows you to see what your profits are when you subtract dividends from your profits. In some cases, when dividends are paid out to shareholders, your net income can be positive and your retained earnings negative.
Understanding how much of your earnings are retained is crucial to fully understanding how profitable your business has been.