How to find and calculate retained earnings for small business owners

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 retained earnings and how to calculate it is essential for any business. This article outlines everything you need to know, 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
• Understanding the equity section of 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 affects the retained earnings balance?

As your business grows and changes, you’ll find that its retained earnings balance 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. 

Are 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.

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.

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.

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)

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.

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.

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:

Use a balance sheet to calculate retained earnings

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

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.

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:

Calculating retained earnings FAQs

Calculating your retained earnings balance can bring up lots of questions, so we answered the most common ones below. 

How are retained earnings calculated on a balance sheet?

Retained earnings are calculated as the total of all prior years' net income plus any dividends paid to shareholders, minus all distributions to shareholders and any appropriations. The retained earnings formula is: 

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

Ending Retained Earnings

What is the retained earnings normal balance?

The normal balance in a company’s retained earnings account is a positive balance, indicating that the business has generated a credit or aggregate profit. This balance can be relatively low, even for profitable companies, since dividends are paid out of the retained earnings account. Accordingly, the normal balance isn’t an accurate measure of a company’s overall financial health.

Conversely, if a company’s retained earnings account has a negative balance, this is called a “deficit” or “accumulated deficit.” A negative retained earnings balance is common for startups since the company incurs losses before turning a profit.

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.

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