Retained Earnings Formula: Definition, Formula, and Example

Retained earnings represent the portion of your company's net income that remains after dividends have been paid to your shareholders, and 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.

As a result, 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

What Are Retained Earnings?

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. So, retained earnings are the profits of your business that remain after the dividend payments have been made to the shareholders since its inception.

Every time your business makes a net profit, the retained earnings of your business increase, and a net loss leads to a decrease in the retained earnings of your business.

Retained earnings are critical for any business as they help with:

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

Example of Retained Earnings Calculation

The following figures have been 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.

Your company's equity investors, who are long term investors, will seek periodic payments in the form of dividends as a return on the money invested by them in your company.

Traders in your company will also seek dividend payments as they look for short-term gains, and many administering authorities treat dividend income as tax-free, which is why many investors prefer dividends over capital/stock gains as such gains are taxable.

Management, on the other hand, will often 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.

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

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

Using Retained Earnings

The following ways are how retained earnings can be put to use by your business:

Paying Off Existing Debts

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

Funding Expansion

This amount can be used to fund the expansion of your business, such as building a new plant, upgrading the existing infrastructure, research and development, or hiring new employees.

Distributing Dividends

This money can partly be distributed as dividends to the stockholders, while also being reinvested for business growth.

Funding New Product Launches

Retained earnings can also be used to fund new product launches, like when a stationery manufacturer launches a new variant of an item or launches a new item to strengthen its market position.

Providing For Merger/Acquisition

This 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 with a cushion against any economic downturn and give you the requisite support required to sail through depression.

Funding Share Repurchase

The retained earnings amount can also be used for share repurchases which can help improve the value of your company stock.

Management and Retained Earnings

Management knows that shareholders prefer receiving dividends, but they may not distribute dividends to stockholders. If they are confident that this surplus income can be reinvested in the business, then it can create more value for the stockholders by generating higher returns.

In fact, both management and 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.

Both management and stockholders would also 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, so, management must maintain a balance between distributing dividends and retaining profits.

Dividends and Retained Earnings

Companies may pay out either cash or stock dividends, and in the case of cash dividends they result in an outflow of cash and are paid on a per-share basis.

Cash Dividend Example

If a company declared a $1 cash dividend on all 100,000 outstanding shares, then 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 will get reduced by $100,000. This outflow of cash would also lead to a reduction in the retained earnings of the company as dividends are paid out of retained earnings.

Stock Dividend Example

Stock dividends are paid out as additional shares as fractions per existing shares to the stockholders.

For example, if a company declares a stock dividend of 10%, meaning the company would have to issue 0.10 shares for each share held by the existing stockholders. If you as a shareholder of the company owned 200 shares, you would then own an 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. As a result, each shareholder has additional shares after the stock dividends are declared, but their stake remains the same.

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 an 0.2% (200/100,000) stake in the company prior to the stock dividend, you still own a 0.2% stake (220/110,000), meaning nothing changes as far as the company is concerned. 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 due to the increase in the number of shares, dilution of the shareholding takes place, which reduces the book value per share, and the reduction in book value per share reduces the market price of the share accordingly.

To summarise, the total market value of the company should not change, but what should change is the per-share market value, which will decrease.

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). 

Meaning, stock dividends lead to the transfer of the amount from the retained earnings account to the common stock account.

Limitations of Retained Earnings

There are some limitations with retained earnings, as these figures alone don't provide enough material information about the company. Even if you keep track of the retained earnings figure of the company over a period of time, you'll only be able to understand the tendency of the company to retain earnings, or how much net profit amount is the company reinvesting.

As an investor, it's important to know the retained earnings figure, what returns the company has been able to generate from the retained earnings and if reinvesting profits are more attractive over other investment opportunities.

Retained Earnings Example

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

The retained earnings figure is based on the opening balance (which is the previous year’s closing retained earnings balance), net profit or loss, and dividends paid during that accounting period.

It is important to note that the retained earnings amount can be negative, this happens when companies have net losses or payout dividends more than what is in the retained earnings account.

What Makes Up Retained Earnings

Using 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. This balance can be both in the positive or the negative, depending on the net profit or losses made by the company over the years and the amount of dividends paid. The beginning period retained earnings is the previous year’s retained earnings, as appears on the previous year’s balance sheet.

Net Profit/Net Loss During an Accounting Period

This is the net profit or loss figure from the current accounting period, from which the retained earnings amount is calculated. A net profit would mean an increase in retained earnings, where a net loss would reduce the retained earnings. As a result, any item, such as revenue, COGS, administrative expenses, etc that impact the Net Profit figure, can impact the retained earnings amount.

Cash and Stock Dividends Paid During the Accounting Period

Dividends are paid out of retained earnings of the company, and using both cash and stock dividends can 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, and often companies will show this as a separate line item.

Retained earnings are calculated by adding/subtracting, the current year’s net profit/loss, to/from the previous year’s retained earnings, then subtracting dividends paid in the current year from the same.

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

How Do You Prepare a Retained Earnings Statement?

Using the example of Company A, the following steps will need to be followed when preparing the retained earnings statement:

Give the Heading to Statement

The first step is to provide a proper heading for 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’; and finally, provide the year for which such a statement is being prepared in the third line (For the Year Ended 2023 in this case).

Specify the Beginning Period Retained Earnings

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. In our example, December 2023 is the current year for which retained earnings need to be calculated, so December 2022 would be the previous year. Meaning the retained earnings balance as of December 31, 2022 would be the beginning period retained earnings for the year 2023.

Company A

Retained Earnings Statement

For Year Ended December 31, 2023

Add Current Period Net Profit or Subtract Net Loss

Next, add the net profit or subtract the net loss incurred during the current period, which is 2023. Since Company A made a net profit of $30,000, we will add $30,000 to $100,000.

Subtract Dividends Paid to the Investors

After adding/subtracting the current period's net profit/loss to/from the beginning period retained earnings, you'll need to subtract the 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. For example, for a $1 cash dividend declared on all 100,000 outstanding shares by the company, the journal entries would appear as follows:

This means both retained earnings and cash will be 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. This means each shareholder now holds an additional number of shares of the company.

There is no change in the shareholder’s when stock dividends are paid out, however, you'll need to transfer the amount from the retained earnings part of the balance sheet to the paid-in capital. The amount transferred to the paid-in capital will depend upon whether the company has issued a small or a large stock dividend.

For example, if 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, then journal entries would appear as follows:

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