What Are Retained Earnings?
- 1 What Are Retained Earnings?
- 2 How To Calculate Retained Earnings?
- 3 Retained Earnings Formula:
- 4 Stock Dividend Calculation: Example
- 5 Retained Earnings vs. Revenue vs. Profit – Explained
- 6 What are Negative Retained Earnings?
- 7 Dividends vs. Retained Earnings - Explained
- 8 Limitations of Retained Earnings
Retained earnings are the amount of net income left over for the business after it has paid out dividends to its shareholders.
The retained earnings surge whenever your business makes a profit and plunge each time you withdraw some from these profits as dividend payout.
Retained earnings are net earnings that do not get distributed to shareholders and that the company decides to reinvest.
Many companies turn to retained earnings as a way of financing the company. It is an effective way to avoid the outflow of money, and it does not resort to new obligations (that is, more indebtedness).
In the blog, we will be discussing how to calculate retained earnings with perfect examples.
How To Calculate Retained Earnings?
The formula applied for calculating retained earnings is pretty simple. Adding the current retained earnings with profit/loss and subtracting the amount from dividends are retained earnings of your business.
The retained earnings are those net earnings that the company has not distributed among shareholders. Therefore, it has decided to reinvest in the company to achieve growth in the business.
Similarly, it may use these profits to increase the workforce, improve the budgets dedicated to research, have greater liquidity, prevent the outflow of money, cancel financial debts, etc.
With them, the company can finance its operations so that it does not have to apply for financial loans, and it saves the cost of interest.
To calculate such profits, subtract expenses from total income. Also, remove the part that corresponds to the distribution of dividends.
Retained Earnings Formula:
Current retained earnings + Profit/Loss - Dividends = Retained earnings
The online accounting software will calculate the retained earnings when it generates a statement of retained earnings, balance sheet, and other financial statements of your business. If you are manually calculating your retained earnings, you will be required to figure out the three variables mentioned below before applying them to the above accounting equation:
- Your initial/ current retained earnings. It is the amount with which your retained earnings balance has finished since the last time you calculated your retained earnings. In cases where you maintain a balance sheet every month, you need to work with the retained earnings of the previous month.
- One can extract Net profit/net loss from the income statement for the current accounting period. Above all, in cases where you generate the same every month, use the net income of the current month or net loss to calculate retained earnings.
- Dividends that you distributed at present get fetched from the company profit, and the shareholders decide to bring it out of the company. Whenever you issue a cash dividend, every shareholder gets paid in cash. The more the shareholders have, the merrier the value of their dividend shares.
Retained Earnings Calculation With Example
Let us assume that your company started on February 1, 2020. That time your retained earnings balance will read $0. In other words, you have no earnings to include.
For example, we assume that your earnings for January are $2000 in net income per your income statement and without any issuance of dividends. That complies that on March 1, retained earnings of your company will be $2000.
If we put the above values in the retained earnings equation, we derive:
Current retained earnings + Net Income - Dividends = Retained earnings
$0 + $2000 - $0 = $2000
*You earned $2000 and after that, retained all of them that become your retained earnings.
Calculate The Effect Of A Dividend On Retained Earnings
At times, the company wishes to reward its shareholders with dividends without giving any cash away. They issue it in the type of a stock dividend, which is the dividend payment but made in shares rather than in cash.
Retained earnings equation after a stock dividend issuance, retained earnings calculation comprises additional steps to figure out the number of dividends you end up distributing. Now figure out the FMV (Fair Market Value) of shares before distribution.
Then, figure out the number of shares you have to give that should not be above a certain percentage of the equity with the company, as the company usually issues a part of its stock as a dividend.
Retained Earnings Equation: Current retained earnings + Net Income - (No. of shares x FMV of each share) = Retained earnings
Stock Dividend Calculation: Example
For instance, you have a profitable jewelry business. In April, your business continued its growth trajectory, leading to a profit of $20,000. Your company has expansion plans. Therefore, you decided to keep that money for future reinvestment in the industry. You waive cash dividend and, preferably, plans to issue a 5% stock dividend on the alternate side.
Now, we will assume that your company has a total of 15,000 outstanding shares of common stock, and as per your determination, the FMV stands at $10 for each share. As a result, you would issue 100 shares in the dividend, and the reduced retained earning for every share counts at $10:
Current retained earnings + Net Income - (No. of shares x FMV of each share) = Retained earnings
$17,000 + $20,000 - (100 x $10) = $27,000
*On May 1, your retained earnings were $27,000 for the business.
ABOUT: Working Capital and Stockholders Equity
However, all that has to be concerned is with the equity section of the working capital, balance sheet, and stockholder equity that are varied from retained earnings. Owners’ equity accounts for the company’s worth if you decide to dissolve all the assets. The accounting equation for calculating the stockholder’s equity is:
Total Assets - Total Liabilities = Stockholders Equity
Resources that your small business enterprise has at its disposal to bear daily operations get referred to as your business working capital. Similarly, its equation will be:
Current Assets - Current Liabilities = Working Capital
Retained Earnings vs. Revenue vs. Profit – Explained
Retained earning has its meaning in the choice of words itself. If a company registers profit, it can do two things.
- Keep the whole profit with itself, and invest it in the business.
- Keep a part of it with itself and divide the rest of it within shareholders.
This retained earnings (profit) increases when the company makes new profits through different sources.
Revenue is a gross financial figure. Whatever the organization has earned with its operations is called its revenue. It does not consider overhead costs operating expenses, and other such items. It is a good indicator of growth. However, it will not show the exact picture.
Profits are nothing but gains that your business registers in its operations. It is similar to revenue.
Selling Price- Cost Price= Profits
What are Negative Retained Earnings?
As we all know, profit is a positive figure, and loss is a negative figure.
We learned that we arrive at retained earnings after deducting shareholders' dividends from the company's profits.
We also know that accounting does not leave financial events unrecorded in the books. Therefore, when a company records a loss, this is also registered in their books, under retained earnings.
Here the loss has exceeded the profit registered previously as earlier retained earnings. It is why we call it negative retained earnings.
When a company distributes dividends more than its profits/ earnings from its day of foundation, it gets recorded as a debit balance in the retained earnings account instead of a credit balance, which happens when the company has achieved profits. In its balance sheet, it will get recorded as an Accumulated Deficit.
Dividends vs. Retained Earnings - Explained
A company may choose to distribute dividends in two forms:
If it chooses to distribute its retained earnings through cash dividends, it will lose a part of its liquidity. After that, the company's asset value will reduce in the balance sheet. It gets recorded in the accounts as net reduction.
If it distributes its retained earnings by stock dividends, it will not facilitate cash outflow. This retained earning will get transferred to common stock. There is no real value, as the per-share market price gets adjusted with the stock dividend. It reduces value per share, which impacts capital accounts, which further deteriorates the retained earnings.
Companies that want to expand their business, buy new machinery, invest in R&D, increase the scale of operations, and engage in other such events find it a cheaper source of finance. In conclusion, they will keep all or a big chunk of their profits as retained earnings. It helps them achieve their long-term expansion goals.
Matured/giant companies do not have many expansion options, as they have already reached their maximum level. Therefore, these companies generally hand out dividends as they do not need excess retained earnings.
Limitations of Retained Earnings
Even though retained earnings are the cheapest source of business finance, they also have a fair share of limitations:
When investors do not get a good return on investment, it leaves them dissatisfied. It can hamper reputation and goodwill in the long run.
From the eye of a business analyst, the accurate retained earnings are not a source of meaningful interpretation to a company's growth. By observing its growth, one may know how much the company has added to its retained earnings over time. However, it will not give any meaningful insight.
At times, the company may invest its retained earnings in a loss-making idea, which will give negative returns. On the contrary, if the company had distributed this profit, it would have a strong backing of investors.
In conclusion, retained earnings are a part of a company's equity in its balance sheet.
An accountant will calculate it at the end of an accounting period, and an increase or decrease in them is the result of the net income and dividends paid in that period. Finally, one must note that they will provide a financial mechanism. A company must enjoy good financial health.
We hope this blog was informative enough to end your issues and queries about your company's retained earnings equation. Keeping track of your companies' financial health is vital; calculating your company's total profit and revenue will support the business in the long run for commercial success.