Retained earnings represent the portion of the net income of your company that remains after dividends have been paid to your shareholders. That is the amount of residual net income that is not distributed as dividends but is reinvested or ‘ploughed back’ into the company.

Retained earnings appear on the liability side of your company’s balance sheet under shareholders’ equity and act as an important source of self-financing or internal financing. Hence, retained earnings:

• serve as a convenient and economical source of internal finance
• reduce your business entity’s dependence on external funds
• can be used to pay off external debt, fund additional assets, and for growth and expansion of your business

In this article, you will learn about retained earnings, the retained earnings formula and calculation, how retained earnings can be used, and the limitations of retained earnings.

What Is Retained Earnings?

Retained earnings refer to the residual net income or profit after tax which is not distributed as dividends to the shareholders but is reinvested in the business. Typically, the net profit earned by your business entity is either distributed as dividends to shareholders or is retained in the business for its growth and expansion.

Thus, retained earnings are the profits of your business that remain after the dividend payments have been made to the shareholders since its inception. So, each time your business makes a net profit, the retained earnings of your business increase. Likewise, a net loss leads to a decrease in the retained earnings of your business.

Furthermore, retained earnings are critical for any business as they help in:

• meeting the fixed and working capital needs of the business
• providing funds for growth and expansion
• funding for new assets
• paying off external loans, and
• withstanding economic downturn

Retained Earnings Formula and Calculation

The retained earnings formula calculates the balance in the retained earnings account at the end of an accounting period. As stated above, it is the profit after tax that remains after the dividends have been distributed to the shareholders. Accordingly, the retained earnings formula is as follows:

Retained Earnings = + Retained Earnings at the beginning of the accounting period

+ Net Profit ((-) or Net Loss) during an accounting period

– Dividends Paid (both Cash Dividends and Stock Dividends)

where,

Beginning Period Retained Earnings is the balance in the retained earnings account as at the beginning of an accounting period. That is the closing balance of the retained earnings account as in the previous accounting period. For instance, if you prepare a yearly balance sheet, the current year’s opening balance of retained earnings would be the previous year’s closing balance of the retained earnings account.

Net Profit or Net Loss in the retained earnings formula is the net profit or loss of the current accounting period. For instance, in the case of the yearly income statement and balance sheet, the net profit as calculated for the current accounting period would increase the balance of retained earnings. Similarly, in case your company incurs a net loss in the current accounting period, it would reduce the balance of retained earnings. Since all profits and losses flow through retained earnings, any change in the income statement item would impact the net profit/net loss part of the retained earnings formula.

Dividends paid are the cash and stock dividends paid to the stockholders of your company during an accounting period. Where cash dividends are paid out in cash on a per-share basis, stock dividends are dividends given in the form of additional shares as fractions per existing shares. Both cash dividends and stock dividends result in a decrease in retained earnings. The effect of cash and stock dividends on the retained earnings has been explained in the sections below.

There can be cases where a company may have a negative retained earnings balance. This is the case where the company has incurred more net losses than profits to date or has paid out more dividends than what it had in the retained earnings account.

Example of Retained Earnings Calculation

The following figures are taken from the income statement and balance sheet of Company A:

Retained Earnings of Company A as on 31st December 2019 = Beginning Period Retained Earnings + Net Profit ((-) Net Loss) during 2019 – Cash Dividend – Stock Dividend

= $100,000 + $30,000 – $10,000

= $120,000

What do Retained Earnings tell You?

When your business earns a surplus income, you have two alternatives. You can either distribute surplus income as dividends or reinvest the same as retained earnings.

The equity investors of your company await dividend payments. These are the long term investors who seek periodic payments in the form of dividends as a return on the money invested by them in your company.

Likewise, the traders also are keen on receiving dividend payments as they look for short-term gains. In addition to this, many administering authorities treat dividend income as tax-free, hence many investors prefer dividends over capital/stock gains as such gains are taxable.

However, management on the other hand prefers to reinvest surplus earnings in the business. This is because reinvestment of surplus earnings in the profitable investment avenues means increased future earnings for the company, eventually leading to increased future dividends.

When it comes to investors, they are interested in earning maximum returns on their investments. Where they know that management has profitable investment opportunities and have faith in the management’s capabilities, they would want management to retain surplus profits for higher returns.

Therefore, the company must maintain a balance between declaring dividends and retaining profits for expansion.

Using Retained Earnings

The following are the ways in which retaining earnings can be put to use by your business entity:

• Paying Off Existing Debts

Retained earnings can be used to pay off existing outstanding debts or loans that your business owes.

• Funding Expansion

The amount can be used to fund expansion such as building a new plant, upgrading the existing infrastructure, research and development, hiring new employees, etc

• Distributing Dividends

The money can partly be distributed as dividends to the stockholders and partly be reinvested for business growth

• Funding New Product Launches

Retained earnings can also be used to fund new product launches. For instance, a stationery manufacturer can launch a new variant of its existing item or launch a new stationery item altogether to strengthen its market position

• Providing For Merger/Acquisition

The amount can be used to fund a partnership or merger/acquisition that generates solid business opportunities

• Meeting Unforeseen Contingencies

Retained earnings also provide your business a cushion against the economic downturn and give you the requisite support to sail through depression.

• Funding Share Repurchase

The retained earnings amount can also be used for share repurchase to improve the value of your company stock.

Management and Retained Earnings

As mentioned earlier, management knows that shareholders prefer receiving dividends. Yet, it may not distribute dividends to stockholders. This is because it is confident that if such surplus income is reinvested in the business, it can create more value for the stockholders by generating higher returns.

In fact, both management and the investors would want to retain earnings if they are aware that the company has profitable investment opportunities. And, retaining profits would result in higher returns as compared to dividend payouts.

Likewise, both the management as well as the stockholders would want to utilize surplus net income towards the payment of high-interest debt over dividend payout.

Distributing dividends or retaining surplus profits is a complex decision. Thus, management must maintain a balance between distributing dividends and retaining profits.

Dividends and Retained Earnings

As stated earlier, companies may pay out either cash or stock dividends. Cash dividends result in an outflow of cash and are paid on a per-share basis.

Cash Dividend Example

For instance, a company may declare a $1 cash dividend on all its 100,000 outstanding shares. Accordingly, the cash dividend declared by the company would be $ 100,000.

Since cash dividends result in an outflow of cash, the cash account on the asset side of the balance sheet gets reduced by $100,000. Also, this outflow of cash would lead to a reduction in the retained earnings of the company as dividends are paid out of retained earnings.

Stock Dividend Example

Stock dividends, on the other hand, are the dividends that are paid out as additional shares as fractions per existing shares to the stockholders.

For instance, a company may declare a stock dividend of 10%, as per which the company would have to issue 0.10 shares for each share held by the existing stockholders. Thus, if you as a shareholder of the company owned 200 shares, you would own 20 additional shares, or a total of 220 (200 + (0.10 x 200)) shares once the company declares the stock dividend.

Now, you must remember that stock dividends do not result in the outflow of cash. In fact, what the company gives to its shareholders is an increased number of shares. Accordingly, each shareholder has additional shares after the stock dividends are declared, but his stake remains the same.

Say, if the company had a total of 100,000 outstanding shares prior to the stock dividend, it now has 110,000 (100,000 + 0.10×100,000) outstanding shares. So, if you as an investor had a 0.2% (200/100,000) stake in the company prior to the stock dividend, you still own a 0.2% stake (220/110,000). So, nothing changes as far as the company is concerned. Thus, if the company had a market value of $2 million before the stock dividend declaration, it’s market value still is $2 million after the stock dividend is declared. This is because due to the increase in the number of shares, dilution of the shareholding takes place, which reduces the book value per share. And this reduction in book value per share reduces the market price of the share accordingly.

This is to say that the total market value of the company should not change. What should change is the per-share market value, which decreases.

Thus, at 100,000 shares, the market value per share was $20 ($2Million/100,000). However, after the stock dividend, the market value per share reduces to $18.18 ($2Million/110,000). Thus, stock dividends lead to the transfer of the amount from the retained earnings account to the common stock account.

Limitations of Retained Earnings

The disadvantage of retained earnings is that the retained earnings figure alone doesn’t provide any material information about the company. In fact, even if you keep track of the retained earnings figure of the company over a period of time, you are only able to understand the tendency of the company to retain earnings, that is how much net profit amount is the company reinvesting.

As an investor, you would be keen to know more about the retained earnings figure. For instance, you would be interested to know the returns company has been able to generate from the retained earnings and if reinvesting profits are attractive over other investment opportunities.

Example of Retained Earnings

As mentioned earlier, retained earnings appear under the shareholder’s equity section on the liability side of the balance sheet. Companies today show it separately, pretty much the way its shown below. The following are the balance sheet figures of IBM from 2015 – 2019.

Source: marketwatch.com

Retained earnings are calculated by subtracting dividends from the sum total of retained earnings balance at the beginning of an accounting period and the net profit or (-) net loss of the accounting period.

As per the retained earnings formula, the retained earnings figure is based on the opening retained earnings balance (which is nothing but the previous year’s closing retained earnings balance), net profit or loss, and dividends paid during the accounting period. Thus, the retained earnings amount can be negative where companies have net losses or payout dividends more than what is in the retained earnings account.

What Makes up Retained Earnings

As per the retained earnings formula, there are three components of the retained earnings:

Retained Earnings = Retained Earnings Beginning Period Balance + Current Period Net Profit (- Current Period Net Loss) – Cash Dividends – Stock Dividends.

• Retained Earnings Beginning Period Balance

This is the amount of retained earnings to date, which is accumulated earnings of the company since its inception. Such a balance can be both positive or negative, depending on the net profit or losses made by the company over the years and the amount of dividend paid. The beginning period retained earnings is nothing but the previous year’s retained earnings, as appearing in the previous year’s balance sheet.

• Net Profit/Net Loss During an Accounting Period

This is the net profit or net loss figure of the current accounting period, for which retained earnings amount is to be calculated. A net profit would lead to an increase in retained earnings, whereas a net loss would reduce the retained earnings. Thus, any item such as revenue, COGS, administrative expenses, etc that impact the Net Profit figure, certainly affects the retained earnings amount.

• Cash and Stock Dividends Paid During the Accounting Period

As stated earlier, dividends are paid out of retained earnings of the company. Both cash and stock dividends lead to a decrease in the retained earnings of the company.

How Do You Calculate Retained Earnings on the Balance Sheet?

Retained earnings appear under the shareholder’s equity section on the liability side of the balance sheet. Today, companies show retained earnings as a separate line item. Retained earnings are the residual net profits after distributing dividends to the stockholders.

Retained earnings are calculated by adding the current year’s net profit (if it’s a net loss, then subtracting the current period net loss) to (or from) the previous year’s retained earnings (which is the current year’s retained earnings at the beginning) and then subtracting dividends paid in the current year from the same.

Thus, to calculate retained earnings on the balance sheet, you need three items as per the retained earnings formula: beginning period retained earnings, current year net profit/loss, and dividends paid (cash and stock dividends.

How Do You Prepare a Retained Earnings Statement?

Let’s go back to the example of Company A, as mentioned earlier. The following steps need to be followed for preparing the retained earnings statement:

• Give the Heading to Statement

The first step is to provide a proper heading to the statement. The heading includes three things. In the first line, provide the name of the company (Company A in this case). Then, mark the next line, with the words ‘Retained Earnings Statement’. Finally, provide the year for which such a statement is being prepared in the third line (For the Year Ended 2019 in this case).

• Specify the Beginning Period Retained Earnings

As stated earlier, retained earnings at the beginning of the period are actually the previous year’s retained earnings. This can be found in the balance of the previous year, under the shareholder’s equity section on the liability side. Since in our example, December 2019 is the current year for which retained earnings need to be calculated, December 2018 would be the previous year. Thus, retained earnings balance as of December 31, 2018, would be the beginning period retained earnings for the year 2019.

Company A

Retained Earnings Statement

For Year Ended December 31, 2019

• Add Current Period Net Profit or Subtract Net Loss

Now, add the net profit or subtract the net loss incurred during the current period, that is, 2019. Since company A made a net profit of $30,000, therefore, we will add $30,000 to $100,000.

• Subtract Dividends Paid to the Investors

After adding the current period net profit to or subtracting net loss from the beginning period retained earnings, subtract cash and stock dividends paid by the company during the year. In this case, Company A paid out dividends worth $10,000, so we’ll subtract this amount from the total of Beginning Period Retained Earnings and Net Profit.

How to Calculate the Effect of a Cash Dividend on Retained Earnings?

Cash dividends are dividends paid in cash on a per-share basis. Let’s look at the journal entries when cash dividends are issued to understand the effect of cash dividends on retained earnings. For $1 cash dividends declared on all 100,000 outstanding shares by the company, the journal entries would be as follows:

Thus, both retained earnings and cash get reduced by $100,000

How to Calculate the Effect of a Stock Dividend on Retained Earnings?

Since stock dividends are dividends given in the form of shares in place of cash, these lead to an increased number of shares outstanding for the company. That is, each shareholder now holds an additional number of shares of the company.

As stated earlier, there is no change in the shareholder’s when stock dividends are paid out. However, you need to transfer the amount from the retained earnings part of the balance sheet to the paid-in capital. Now, how much amount is transferred to the paid-in capital depends upon whether the company has issued a small or a large stock dividend.

Let’s look at the journal entries when stock dividends are issued to understand the effect of stock dividends on retained earnings. As per the earlier example, the company paid a stock dividend at 10% on 100,000 outstanding shares, with a market value per share as $20 and par value $1. The journal entries in such a case would be as follows:

FAQ’s

• How do you calculate retained earnings on a balance sheet?

Retained earnings are calculated by adding the current year’s net profit (if it’s a net loss, then subtracting the current period net loss) to (or from) the previous year’s retained earnings (which is the current year’s retained earnings at the beginning) and then subtracting dividends paid in the current year from the same.

• What is the beginning retained earnings formula?

The beginning period retained earnings appear on the previous year’s balance sheet under the shareholder’s equity section. The beginning period retained earnings are thus the retained earnings of the previous year.

• What are the three components of retained earnings?

The three components of retained earnings include the beginning period retained earnings, net profit/net loss made during the accounting period, and cash and stock dividends paid during the accounting period.

• How do you record retained earnings?

The retained earnings are recorded under the shareholder’s equity section on the balance as on a specific date. Thus, retained earnings appearing on the balance sheet are the profits of the business that remain after distributing dividends since its inception.

• What happens to retained earnings at year-end?

At the end of the accounting period, the retained earnings are recorded on the balance sheet as cumulated income from the previous year, including the current year’s net income/lossless dividends paid in the accounting period.

• Is retained earnings on the income statement?

Retained earnings appear on the balance sheet under the shareholders’ equity section. However, they are calculated by adding the current year’s net profit/loss (as appearing in the current year’s income statement) and subtracting cash and stock dividends from the beginning period retained earnings balance.

• What are negative retained earnings?

Negative retained earnings mean a negative balance of retained earnings as appearing on the balance sheet under stockholder’s equity. A business entity can have a negative retained earnings balance if it has been incurring net losses or distributing more dividends than what is there in the retained earnings account over the years.

• What is the journal entry for retained earnings?

The journal entry for retained earnings would be as follows:

(Dr) Profit and Loss

(Cr) Retained Earnings

• What affects retained earnings?

Retained earnings are affected by an increase or decrease in the net income and amount of dividends paid to the stockholders. Thus, any item that leads to an increase or decrease in the net income would impact the retained earnings balance.