How to Calculate Retained Earnings

Have you ever wondered what keeps a company ticking financially beyond its immediate profits and losses? The secret sauce, often overlooked but crucial, is something called “retained earnings.” This concept might sound like something out of an advanced accounting textbook, but it is actually a fundamental aspect of any business’s financial health. Today, we will discuss how to calculate retained earnings, what retained earnings are, and how they work.

What Are Retained Earnings?

At its core, retained earnings represent the surplus income a company has accumulated over the years after paying dividends to shareholders. Think of it as a business’s savings account. However, this money is not just sitting idle. It is reinvested into the company, be it for research and development, debt reduction, or expansion plans.

Vlad / Pexels / Retained earnings are the ‘final profit’ a company is left with after all expenses and taxes.

Notice that the company can use this profit to invest in new things. So, in essence, retained earnings reflect the company’s ability to generate profit and use it judiciously for long-term growth.

How Do Retained Earnings Work?

To understand how retained earnings work, it is essential to understand the concept of the accounting cycle. At the end of each financial period, companies calculate their net income (or loss) and decide how much to distribute as dividends.

So, why do companies care about retained earnings? For starters, it is a critical indicator of financial health and operational efficiency. A healthy retained earnings balance suggests that the company is adept at earning more than it spends and has the discipline to reinvest in its future.

Apart from that, retained earnings provide a cushion against economic downturns, allowing businesses to continue operations even in challenging times without resorting to excessive debt or additional equity.

Max / Pexels / Whatever is not distributed from the net income is added to the retained earnings from the previous period, thereby increasing or decreasing the retained earnings balance.

How to Calculate Retained Earnings?

Getting down to the brass tacks, how to calculate retained earnings is a question that intrigues many. The formula is surprisingly straightforward:

Retained Earnings = Beginning Retained Earnings + Net Income (or Loss) – Dividends

Let’s break it down:

• Beginning Retained Earnings: This is the amount of retained earnings at the start of the period (typically the beginning of a fiscal year).
• Net Income (or Loss:) This is the total profit or loss the company generated during the period, calculated as revenues minus expenses.
• Dividends: This is the amount paid out to shareholders from the net income.

By plugging in these figures, a company can ascertain its retained earnings at the end of a period, providing insights into its financial trajectory.

What Is the Retained Earnings Formula?

Sora / Pexels / Here’s an example of the retained earnings formula: Retained Earnings = $100,000 + $50,000 – $10,000 = $140,000

To make it more tangible, let’s apply the retained earnings formula to a hypothetical scenario. Imagine a company, Widget Inc., starts its fiscal year with $100,000 in retained earnings. Throughout the year, Widget Inc. earns a net income of $50,000 and pays out $10,000 in dividends. Using our formula:

At the end of the year, Widget Inc.’s retained earnings would be $140,000.

How Does Net Income Impact Retained Earnings?

The relationship between net income and retained earnings is direct and pivotal. Net income serves as the primary fuel for increasing retained earnings, reflecting the company’s operational success and its management’s decisions on dividend payouts.

A consistent net income growth leads to higher retained earnings, assuming dividends do not eat up all the profits, which in turn strengthens the company’s financial foundation.