What Are Retained Earnings
Retained Earnings is a part of business revenue reserved for reinvesting back into the business and not distributed as dividends. Retained earnings are technically directly proportional to the profits of a business. They go up as your business earns a profit and drops down if your business suffers a loss or withdraws earnings from the business to distribute dividends. In simple words, Retained Earnings are a running total of how much profits your business has managed to retain.
Note that the difference between cash and accrual accounting can also affect your total retained earnings. So if you’re someone who lacks financial knowledge, it is better to outsource your financial reporting services to avoid mishaps.
This article will discuss how you can calculate retained earnings along with the retained earnings equations. Also, we’ll the impacts of net income and dividends on retained earnings. So let’s head into that.
What Is The Purpose Of Retained Earnings
The Basic functions of retained earnings vary. The most common purpose of retained earnings is to reinvest it into the business. These earnings are spent on fixed assets like machines and equipment to increase the overall production or spend on research and development. Either way, the company aims to expand overall growth for earning more revenue in the future.
A company also uses these earnings for distributing dividends among the shareholders or buy back shares. Typically, this happens when a company believes that it cannot earn sufficient ROI (Return on Investment) by reinvesting retained earnings into the business.
Even though you can handle the calculation of retained earnings with your accounting software’s help while it generates the company’s financial statements like balance sheet and retained earnings statement, but if you prefer doing that manually, here’s the retained earnings equation that you can leverage to calculate it.
How To Calculate Retained Earnings
Retained earnings on the balance sheet are reported under the shareholder’s equity at the end of accounting periods. The formula for retained earnings is quite simple. You have to figure out these simple variables to place them into the equation. These three variables are:
Current Retained Earnings
Current retained earnings are those balances that you ended up with the last time you made a financial statement. For example, if your company generates a balance sheet monthly, the retained earnings of the last month are your current retained earnings.
This is the amount of profit or loss made by the company in the current accounting period. If a company generates an income statement monthly, we will use this month’s profit/loss. Also MATLAB, a mathematical problem-solving programming language can also be used to calculate retained earnings.
Company profits that an owner and shareholders decide to take out of the company and distribute among themselves are called dividends. When cash dividends are issued, each shareholder receives a cash payment. Note that the share of dividends depends upon the number of shares a shareholder owns. For example, a person with more shares will receive a larger share of dividends.
Retained Earnings Formula:
RE = Current Retained Earnings + Profit/Loss – Dividends
Where RE = Retained Earnings
For calculating retained earnings, add the current retained earnings to net profit/loss. Then deduct the dividend payouts. To outline the changes in retained earnings, a summary report called retained earnings statement is also maintained.
Example Of Retained Earnings Calculation
Let’s say a company goes into business on March 1, 2020. The retained earnings on March 1, 2020, will be $0 because the company has no earnings yet that are to be retained. In March, the company earns $5000 in net income and issues no dividends. On April 1, 2020, the retained earnings will be $5000.
$0 + $5000 – $0 = $5000
EffectOf Cash Dividend On Retained Earnings
Following the example mentioned above, let’s say that the company made a profit of $10,000, and the owner decides to payout $3000 as cash dividend to all shareholders. Also, remember your current retained earnings balance is $5000
Current Retained Earnings + Net Profit/Loss – Dividends = Retained Earnings
$5000 + $10,000 – $3000 = $12,000
This means that the company has managed to retain $12,000 as retained earnings.
Effect Of Stock Dividend On Retained Earnings
A company rewards its shareholders with stock dividends without giving away any cash. This is just another method of distributing dividends but in the form of company shares. For that, a company must first determine the FMV (Fair Market Value) of shares and then put it into the retained earnings equation. A company can issue a percentage of total shares as a dividend. This percentage of the shares is the equity of the company. The formula of retained earnings for the stock dividend is
Retained Earnings = Current Retained Earnings + Net Income – (number of shares x FMW of each share)
Example Of Retained Earning In Stock Dividend
Following the example mentioned above, let’s say that the business keeps on doing well and make another $10,000. This time, the company decides to give out a 5% stock dividend instead of a cash dividend.
Let us consider that the company has 10,000 outstanding shares of common stock, and the FMV (Fair Market Value) of each share is $10. This means that the company will issue 500 shares as the stock dividend to shareholders.
$12,000 + $10,000 – (500 x$10) = $17,000
This means that the company has managed to retain $17,000 as retained earnings.
This definitive guide has outlined some of the most important things you should know about retained earnings, how it is calculated, and its importance in the financial analysis. Having that said, you can also read our guide on the PPP loan and cash flow statement to build out your knowledge on these finance topics.