how to calculate retained earnings

Retained Earnings are the part of net income that the company has kept with itself after paying dividends to its shareholders. 

The movement of retained earnings will be parallel to the profit of a business. If there is a growth in profits, it will increase, and if some of these profits are withdrawn as dividend payout, then it will decrease.

Or

It is a part of net earnings that the business decides not to distribute to shareholders. Rather, it keeps it with itself to reinvest in the business.

Many companies turn to RE 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?

Calculating retained earnings is easy. Adding the current RE with profit/loss and subtracting the amount from dividends are RE of your business.

The retained earnings are the net earnings that a company hasn't distributed to shareholders.

Therefore, the company has chosen to keep these profits with itself. The company wants to increase its workforce, improve its budget in R&D, generate greater liquidity, prevent money outflow, reduce financial debts, and others. Hence, this profit will come in handy.

The company will easily fund these operations and avoid costly financial loans. It will save money on the cost of interest too.

To calculate such profits, subtract expenses from total income. Also, remove the part that corresponds to the distribution of dividends.

Retained Earnings Formula:

Current RE + Profit (or) - Loss - Dividends = Retained earnings 

If calculating retained earnings manually, one need to figure out the following three variables before applying them to the formula. However, if someone has employed an online accounting software, it will automatically generate a statement of retained earnings, balance sheet, and other financial statements related to a business.

  • The initial/ current RE. It is the amount with which your RE 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 RE 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.
  • If you and other shareholders decide to have dividends, it will come out of company profits. If you issue cash dividends, every shareholder will get a cash payment. If a shareholder has a large chunk of shares, they will receive a big chunk in dividends too.

Retained Earnings Calculation With Example

Your company XYZ Limited started its operations on Feb 1, 2020. That time your RE balance will read $0. In other words, you don't have any earnings to include.

For example, we presume 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, RE balance of your company will be $2000.

If we place these values in the retained earnings equation, we get:

Current RE + Net Income - Dividends = Retained earnings

$0 + $2000 - $0 = $2000

*You've earned $2000, but kept all of it as your retained earnings.

Calculate The Effect Of A Dividend On Retained Earnings

At times, a company may want to reward its shareholders, but do not want to lose cash in the process. So, they issue dividends in terms of stocks. It is the dividend payment made in shares instead of cash.

Retained earnings equation after a stock dividend issuance, RE 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.

Now, find out the number of shares to be given. This shouldn't be beyond a certain percentage of the company's equity. Usually, a company issues parts of its socks as dividends.

Retained Earnings Equation: Current retained earnings + Net Income - (No. of shares x Fair Market Value of each share) = Retained earnings

Example: Stock Dividend Calculation

For instance, you have a profitable jewelry business.

In May, your business persists its growth and registers a profit worth $20,000. You wish to open a new branch. Therefore, you opt for issuing stock dividends to prevent the outflow of funds. So, you intend to allocate a 5% stock dividend on the other side.

We will consider that:

Total outstanding shares of common stock: 15,000

As per calculation, fair market value: $10/ each share.

Due to this, you will raise 100 shares for the dividend, and so the reduced RE for reach share will be $10:

Current RE + Net Income - (No. of shares x FMV of each share) = Retained earnings

$17,000 + $20,000 - (100 x $10) = $27,000

Therefore, RE on June 1:  $27,000

ABOUT: Working Capital and Stockholders Equity

Even though working capital, shareholder's equity (paid-in capital/ owner's equity/ stockholder equity), and retained earnings, all are part of the equity section, they aren't the same. Shareholder's equity is a measure of a company's worth, if it can't pay its debts, and is looking forward to liquidation. It can be calculated this way:

Total Assets - Total Liabilities = Stockholders Equity

All the resources a business needs for its everyday operation are known as business working capital. Therefore, its formula will be:

Working Capital= Current Assets - Current Liabilities

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 correct statistics.

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 RE balance 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 RE balance.

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:

  • Cash
  • Stocks

If it chooses to distribute its RE balance through cash dividends, it will lose a part of its liquidity. After that, the company's asset value will reduce in the balance sheet. Bookkeepers write it as a net reduction.

If it distributes its retained earnings by stock dividends, it will not facilitate cash outflow. This RE balance 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 RE balance.

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 RE balance.

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.

Conclusion:

In conclusion, retained earnings are a part of a company's equity in its balance sheet.

After calculating the figure at the end of the accounting cycle, the increase/ decrease is due to 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 & know How To Calculate Retained Earnings.

callnow

Live Support

+1-860-215-2261