How to calculate retained earnings - Formula, examples and video

Every growing business has a set of key metrics that managers use to monitor performance, measure profitability, manage cash flow, and more. There are a handful of metrics to keep on your radar, but one of the most important ones is the retained earnings calculation, which is based on this retained earnings formula:

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

Ending Retained Earnings

Businesses that generate retained earnings over time are more valuable and have greater financial flexibility. It’s safe to say that understanding the retained earnings equation and how to calculate it is essential for any business. This article provides a comprehensive overview of what you need to know about retained earnings, but feel free to jump straight to your topic of focus below.

Table of Contents: 

• What are retained earnings and why do they matter?
• What affects the retained earnings balance?
• Are retained earnings an asset or a liability?
• How are retained earnings different from dividends and profits?
• How to calculate retained earnings
• Calculate retained earnings on a balance sheet

• Calculating retained earnings FAQs

What are retained earnings and why do they matter?

Retained earnings refer to the portion of a company's net income or profits that it retains and reinvests in the business instead of paying out as dividends to shareholders. It’s an equity account in the balance sheet, and equity is the difference between assets (valuables) and liabilities (debts). 

For instance, if your business has $20,000 left over after covering all its financial responsibilities—including operating expenses like employee salaries—you would report that money as retained earnings.

Businesses use this equity to fund expensive asset purchases, add a product line, or buy a competitor.

What is the retained earnings equation?

The retained earnings equation is a fundamental accounting concept that helps companies calculate the amount of profit that is kept in the business after dividends are distributed to shareholders. The retained earnings calculation is essential for understanding a company's ability to reinvest in itself, pay off debt, or fund its own growth without needing additional outside funding.

How to find retained earnings

To find retained earnings, you’ll need to use a formula to calculate the balance in the retained earnings account at the end of an accounting period.

The retained earnings calculation

Here’s the basic formula for retained earnings:

Retained Earnings = Beginning Retained Earnings + Net Income - Dividends Paid

How to calculate retained earnings

The retained earnings balance is the total amount of company earnings (net income) since the beginning, minus all cash dividends it has paid over time. To visualize these calculations, you can use two financial reporting documents: an income statement and a balance sheet.

Let's break down each component of the equation and how to do the calculation:

Step 1: Find Beginning Retained Earnings: This is the amount of retained earnings carried over from the end of the previous accounting period. You can find this number on the balance sheet under the shareholders' equity section.

Step 2: Add Net Income or Subtract Net Loss: Include the net income or subtract the net loss for the current period. Net income or loss is reported on the income statement and represents the company's profitability after all expenses, including taxes, are deducted from revenues.

• If the company made a profit, add this amount to the beginning retained earnings.
• If the company incurred a loss, subtract this amount from the beginning retained earnings.

Step 3: Subtract Cash Dividends: Subtract any cash dividends paid out to shareholders during the period. Dividends are a distribution of profits to shareholders and reduce the amount of earnings retained in the business.

Step 4: Calculate Ending Retained Earnings: The result after adding net income (or subtracting net loss) to the beginning retained earnings and then subtracting cash dividends will give you the ending retained earnings. This figure shows how much of the company’s profits are retained in the business for future growth or debt repayment, rather than being distributed to shareholders.

What affects the retained earnings balance?

As your business grows and changes, you’ll find that its retained earnings on a balance sheet can be smaller or larger than a previous period. Here are some common transactions that can cause these changes:

• Increase in net income: When a company earns more revenue than the previous year and expenses stay the same, retained earnings could increase. 
• Decrease by a net loss: A growing business that pays higher operating expenses than the previous year could suffer a net loss of income and, ultimately, decreased retained earnings. 
• Payment of cash dividends: If a company sells more shares of its stock to shareholders, the increased expense of cash dividend payouts could decrease retained earnings.

Dividend payments can vary widely, depending on the company and the firm’s industry. Established businesses that generate consistent earnings make larger dividend payouts, on average, because they have larger retained earnings balances in place. However, a startup business may retain all of the company earnings to fund growth.

Retained earnings allow businesses to fund expensive asset purchases, add a product line, or buy a competitor. Your firm’s strategy should influence how you choose to use retained earnings and cash dividend payments.

There are two more things to keep in mind with retained earnings:

1. Stock dividends do not impact retained earnings: When a stock dividend is paid, the company rewards shareholders by issuing more shares rather than a cash payment.
2. Cash dividends reduce the cash balance when the dividend is paid: When a company declares a cash dividend, its total cash balance decreases by the amount of the dividend payment

Note: Cash dividends are payments that a business makes to shareholders from profits or cash reserves. 

Is retained earnings an asset or a liability?

Retained earnings are not an asset. They are a type of equity—the difference between a company’s assets minus its liabilities. Businesses can choose to accumulate earnings for use in the business or pay a portion of earnings as a dividend.

That said, retained earnings can be used to purchase assets such as equipment and inventory. Accordingly, companies with high retained earnings are in a strong position to offer increased dividend payments to shareholders and buy new assets.

How are retained earnings different from dividends?

Retained earnings are net income (profits) that a company saves for future use or reinvests back into company operations. You should report retained earnings as part of shareholders’ equity on the balance sheet.

Alternately, dividends are cash or stock payments that a company makes to its shareholders out of profits or reserves, typically on a quarterly or annual basis.

Retained earnings vs net income

Though cash dividends are the most common payout, remember that stock dividends are another option. Unlike cash payments, stock dividends don’t immediately impact a company’s bottom line.

Use an income statement to figure out your profit

The income statement (or profit and loss) is the first financial statement that most business owners review when they need to calculate retained earnings. This document calculates net income, which you’ll need to calculate your retained earnings balance later.

To find your company’s bottom line, use this net income formula:

Revenue – expenses = net income (net profit)

Net income is an important indicator of your business’s profitability. To calculate net income, also known as net profit, follow these steps:

Step 1: Determine Total Revenue

Revenue refers to sales and any transaction that results in cash inflows. If you sell an asset for a gain, the gain is considered revenue. Company revenue is a line item at the top of the income statement.

Step 2: Calculate Total Expenses

Sum all costs your company incurs, including cost of goods sold, salaries, rent, and other operating expenses.

Step 3: Subtract Total Expenses from Total Revenue

This result is your net income, showing what the company earns after covering all its costs.

Businesses take on expenses to generate more revenue, and net income is the difference between revenue (inflow) and expenses (outflow). Expenses are grouped toward the bottom of the income statement, and net income (bottom line) is on the last line of the statement.

Business owners should use a multi-step income statement that also separates the cost of goods sold (COGS) from operating expenses. 

Net income vs. gross profit

The income statement calculates net income, which is the balance you have after subtracting additional expenses from the gross profit. 

Here are some details that explain gross profit:

• The total revenue minus the COGS
• COGS includes direct materials, including wood and metal materials used to build furniture
• COGS also includes direct labor or labor costs that are directly related to furniture production

So for example, a hypothetical furniture company named Craft earned $120,000 in revenue for the current year. If its total COGS for the current year is $18,000, that leaves a gross profit of $102,000. 

Operating income is another metric to keep in mind. It represents profit generated from day-to-day business operations. Well-managed businesses can consistently generate operating income, and the balance is reported below gross profit. 

Now that you’re familiar with the terms you’ll encounter on an income statement, here’s a sample to serve as a guide.

How much should my retained earnings be?

The appropriate level of retained earnings varies significantly based on factors like industry norms, your company's growth stage, and financial strategies. Here are key considerations to help gauge your retained earnings:

1. Industry Standards

Different industries have varying benchmarks. For instance, tech startups often reinvest heavily to fuel growth, whereas mature utility companies might pay more dividends.

2. Growth Phase

• Startups might have low or negative retained earnings due to reinvestment needs.
• Growth-phase companies often retain more earnings for expansion.
• Mature companies might pay more dividends, resulting in lower retained earnings.

3. Financial Stability

Stable companies might retain more earnings as a safeguard against economic downturns, while those with less risk may distribute more dividends.

4. Future Capital Needs

If significant capital investments are anticipated, retaining earnings to cover these costs can be more advantageous than external financing.

5. Debt Levels

High-debt companies may retain more earnings to reduce debt and improve financial health.

6. Shareholder Expectations

The dividend preferences of shareholders can influence retained earnings, especially in dividend-focused industries.

Regular Evaluation

Regularly assess your retained earnings in the context of your business objectives and shareholder needs, perhaps with the help of financial advisors.

The goal is to maintain a balance that supports your business's health and strategic goals while meeting shareholder expectations.

Income statement sample

If you use it correctly, an income statement will reveal the total net income of your business by calculating the difference between your assets and liabilities. This document is essential as you learn how to calculate retained earnings and other equities.

Here’s an example of a completed income statement:

Calculate Retained Earnings on a Balance Sheet

The next step to figuring out your retained earnings balance is using a balance sheet. Essentially, a balance sheet equation looks like this:

Assets = liabilities + equity

Here’s how the equation works in practice:

Step 1: Add up all the Assets: This could be cash, equipment, and anything else of value the company owns.

Step 2: Add up all the Liabilities: These are all the debts the company must pay.

Step 3: Analyze the Difference: What remains after paying off all liabilities (debts) from the assets is what the owners truly own, known as equity. 

Accountants use the formula to create financial statements, and each transaction must keep the formula in balance. This bookkeeping concept helps accountants post accurate journal entries, so keep it in mind as you learn how to calculate retained earnings. 

Here is an example of how the balance sheet equation works:

Let’s say a business issues a $10,000 bond and receives cash. The company posts a $10,000 debit to cash (an asset account) and a $10,000 credit to bonds payable (a liability account).

The company records that liabilities increased by $10,000 and assets increased by $10,000 on the balance sheet. There is no change in the company’s equity, and the formula stays in balance.

If every transaction you post keeps the formula balanced, you can generate an accurate balance sheet. Note that each section of the balance sheet may contain several accounts.

Is retained earnings a debit or credit?

Retained earnings are typically a credit balance. In accounting, if a company has more profits than losses over time, and after dividends are paid, the retained earnings account will show a credit balance, reflecting the accumulated profits held in the company. If a company consistently operates at a loss, it's possible, though less common, for retained earnings to have a debit balance.

Classifying assets and liabilities

• Current assets: Cash and other assets that you expect to convert into cash in 12 months are less, including accounts receivable and inventory balances
• Current liabilities: Liabilities that you must pay in cash within a year, including accounts payable
• Working capital: Current assets minus current liabilities. To finance short-term obligations, successful businesses maintain a positive working capital balance.

As you work through this part, remember that fixed assets are considered non-current assets, and long-term debt is a non-current liability.

Understanding the equity section of a balance sheet

If a business sold all of its assets and used the cash to pay all liabilities, the leftover cash would equal the equity balance. This is why equity is a company’s real value. When one company buys another, the purchaser buys the equity section of the balance sheet.

Shareholder’s equity section includes common stock, additional paid-in capital, and retained earnings.

• Issuing common stock: Par value is a dollar amount used to allocate dollars to the common stock category. Custom Furniture’s common stock balance is $20,000.
• Posting additional paid-in capital: Additional paid-in capital is the amount of money shareholders invest greater than the common stock balance. The additional paid-in capital balance is $15,000.

Balance sheet sample

Now that you’ve learned how to calculate retained earnings, accuracy is key. The purpose of a balance sheet is to ensure all your bookkeeping journal entries are correct and every penny is accounted for. 

Here’s a detailed example of a completed balance sheet:

Prep early for a stress-free tax season

A company’s equity reflects the value of the business, and the retained earnings balance is an important account within equity. To make informed decisions, you need to understand how financial statements like the balance sheet and the income statement impact retained earnings.

You can retain earnings, pay a cash dividend to shareholders, or choose a hybrid solution that addresses both of those. The details are up to you, and you should use what you’ve learned here to make smart decisions regarding retained earnings and the future of your business. You can stay on top of your earnings, get accurate reports, and easily track transitions with QuickBooks.