What are Retained Earnings?
Retained earnings represent the portion of a company’s profits that is kept within the business instead of being distributed to shareholders as dividends. These earnings accumulate over time and can be used for various purposes, such as funding business expansion, paying off debt, or reinvesting in operations.
Retained earnings are recorded on the company’s balance sheet under shareholders’ equity, showing how much profit has been reinvested in the business rather than paid out to shareholders.
What Is The Purpose of Retained Earnings
Retained earnings serve to reinvest profits back into the business. This reinvestment can fund growth initiatives, such as expanding operations, developing new products, or acquiring assets.
Retained earnings also provide a financial cushion, allowing a company to weather economic downturns, pay off debt, or manage unexpected expenses without raising additional capital. Companies can strengthen their financial stability and support long-term growth by keeping some profits within the business.
How to Find Retained Earnings
Retained earnings, also known as retained profit, are reported on the balance sheet under the shareholder’s equity section at the end of each accounting period.
To calculate RE, the beginning RE balance is added to the net income or reduced by a net loss and then dividend payouts are subtracted.
What is the Retained Earnings Formula?
The retained earnings formula is:
Retained Earnings = Beginning Retained Earnings + Net Income (or Loss) – Dividends Paid
This formula calculates the retained earnings for the current period by adding the beginning retained earnings to the net income (or subtracting if there was a net loss) and then subtracting any dividends paid to shareholders.
How to Calculate Retained Earnings
To calculate retained earnings, follow these steps:
- Start with Beginning Retained Earnings: Find the retained earnings balance at the start of the period, usually listed on the balance sheet from the previous period.
- Add Net Income (or Subtract Net Loss): Determine the net income (or loss) for the current period from the income statement. Add net income to the beginning retained earnings or subtract a net loss.
- Subtract Dividends Paid: If the company distributed dividends during the period, subtract the total dividends paid from the sum of beginning retained earnings and net income.
The result is the retained earnings at the end of the period.
Example:
- Beginning Retained Earnings: $50,000
- Net Income: $20,000
- Dividends Paid: $5,000
Calculation:
- Retained Earnings = $50,000 + $20,000 – $5,000
- Retained Earnings = $65,000
The retained earnings for the period would be $65,000.
FAQ
Why Are Retained Earnings Important for Small Business Owners?
Retained earnings are crucial for small business owners because they provide a source of internal funding. Unlike external financing options, such as loans or investments, retained earnings are generated from the business’s own operations and don’t require repayment or giving up equity.
Key reasons retained earnings are important for small businesses:
- Funding Growth: Small business owners can use retained earnings to invest in new projects, expand operations, or purchase equipment, fostering business growth without taking on additional debt.
- Financial Stability: Having a reserve of retained earnings helps the business manage cash flow during slower periods or unexpected downturns, ensuring operations can continue without interruption.
- Debt Reduction: Retained earnings can be used to pay down existing debt, reducing interest expenses and improving the company’s financial health.
- Increased Value: Reinvesting retained earnings into the business can increase its overall value, making it more attractive to potential buyers or investors.
- Flexibility: Retained earnings offer flexibility, allowing business owners to make strategic decisions without the pressure of external financial obligations.
Overall, retained earnings empower small business owners to maintain control over their company’s finances and strategically invest in its future.
What is included in retained earnings?
Retained earnings include the accumulated net income or loss that a company has earned over time, minus any dividends paid out to shareholders. Specifically, retained earnings consist of:
- Beginning Retained Earnings: The balance of retained earnings carried over from the previous accounting period.
- Net Income (or Loss): The profit (or loss) that the company earned during the current period. This is calculated as revenues minus expenses and taxes. Positive net income increases retained earnings, while a net loss decreases them.
- Dividends Paid: The portion of earnings distributed to shareholders during the period. Dividends are subtracted from retained earnings.
Not Included in Retained Earnings:
- Capital Contributions: Money or assets invested in the company by owners or shareholders are not part of retained earnings.
- Revaluations or Adjustments: Accounting adjustments or asset revaluations do not directly impact retained earnings.
- New Equity Issuance: Proceeds from issuing new shares are not included in retained earnings.
Retained earnings represent the cumulative total of a company’s undistributed profits, reinvested back into the business for future growth and financial stability.
