Businesses need to raise money from investors and ensure they are using that money in the smartest way possible. From there, it’s all about calculating whether your business is making enough money and paying shareholders the dividends they are owed.
Accounting software can be of great assistance when it comes to doing all this math correctly. From there, you should be able to calculate your retained earnings.
What are retained earnings?
Retained earnings are the profits generated by a company that do not need to be paid out to shareholders as dividends. Instead, this sum of money is saved for a period of time and reinvested in the company itself.
This money is typically set aside for a specific objective. This can range from things like research and development to purchasing supplies or a new office space.
For most businesses, there is no right way to spend this money as it’s all about how you want to invest in your company’s future. There is also no right time to start spending retained earnings. Depending on your company’s financial status, it may be wise to wait a few quarters or a few years.
One important consideration to keep in mind, however, is that it is vital to understand the difference between different types of finance-related terms.
Revenue vs. retained earnings
Revenue is typically referred to as a top-line number used to describe a company’s financial performance. It is the total income generated before operating expenses. Retained earnings are a piece of a company's revenue but are calculated only after all other necessary expenses are paid off.
Net income vs. retained earnings
Net income is the bottom line used to describe an organization’s financial performance. This is the earnings after taking out things like operating expenses, administrative costs, payroll and more. Once it has been decided that a portion of net income will be used to invest back into the company, that sum becomes retained earnings.
Dividends vs. retained earnings
Dividends are money paid regularly to shareholders out of an organization's profits. Retained earnings are all profits minus dividends. The change in retained earnings can impact dividends. Changes in retained earnings are also referred to as the statement of retained earnings.
What is a statement of retained earnings?
A statement of retained earnings outlines changes in your company’s retained earnings within a specified period of time. This statement settles the retained earnings at the beginning and the end of a specific period of time. It uses information like your net income from other financial statements.
Why do you need a statement of retained earnings?
Companies release a statement of retained earnings to improve market and shareholder confidence in their organization. Investors are able to evaluate this statement so they can judge the health of the organization. This statement is of importance to the other people within your organization as well.
Members of the board of directors are responsible to shareholders. Outside investors take a look at this money to gauge whether they want to invest in the company. Creditors also take a look at this statement as well. They want to look at a variety of performance measures, such as retained earnings, before they can issue credit to a business.
Essentially, a statement of retained earnings is vital for your company’s growth. This shows your board that your company is worth its time and money.
What are negative retained earnings?
Retained earnings are not always positive. When a company suffers a loss, it needs to be recorded in the retained earnings. This loss can also be referred to as “accumulated deficit.” If this amount exceeds the amount of profits previously recorded as retained earnings, then it is considered to be negative retained earnings.
Even a profitable company can experience negative retained earnings. If the company pays out more dividends than money that is available, this will result in negative retained earnings. This can also be an early indicator of potential bankruptcy as this can imply a long-term series of losses.
How to calculate retained earnings
A company can calculate its retained earnings by using a balance sheet. A balance sheet is made up of assets, liabilities and stockholder equity. This balance sheet is used to ensure the assets on your company’s books are equal to the sum of your company’s liabilities and stockholder equity.
Retained earnings formula
The formula for calculating retained earnings is beginning retained earnings + new net income - dividends.
Each category on the balance sheet can be divided into smaller subcategories. On the assets side of your balance sheet, you should find a line for items like cash, accounts receivable and other current assets. The liabilities side includes line items such as accounts payable and debt.
The stockholder equity side of your balance sheet should include two main categories. The first category includes contributed capital. This typically appears as a common stock line item. The second category is where retained earnings come into play. Your retained earnings are calculated from the money your company has made in its overall history and held onto for future investments, instead of paying out into dividends.
If you are unable to tell what your retained earnings are from this formula, there’s another quick formula you can follow.
Take a look at your total number of assets and liabilities. Subtract liabilities from assets and that total is stockholder equity.
Go to the common stock line item on your balance sheet. Knowing that stockholder equity is made up of common stock and retained earnings, simply take your total stockholder equity and subtract your common stock total. The remaining difference is your retained earnings.
Trying to calculate your retained earnings for the first time can be intimidating. If you are looking for assistance, take a look at the accounting firms listed on G2 Crowd. Any firm on this list can be outsourced to provide comprehensive financial management services to your business.
However, if you want to take the hands-on approach, accounting software is the way to go. This category of software is full of tools to keep your business’ finances in check. These solutions can help you to keep your books accurate and cut down on time spent on recurring tasks. Accounting software typically allows users the ability to create journal entries to adjust transactions and account balances.
Advantage of using retained earnings as a long-term source of funds
Simply put, retained earnings help your company to increase stock value, assure organizational stability and provide money for things like research and expansion without increasing your debt. Retained earnings are added to your business’ balance sheet, which increases stockholder equity, therefore increasing stock value. Increased stock price will attract new investors.
And of course, retained earnings give you the freedom to expand your business in whichever way you see most beneficial. Retained earnings help you give your business the future you have always envisioned for it.
Brynne is the Buyer Inquiry Team Lead at G2 Crowd. In addition to writing, she leads the research specialists in providing personalized software and services recommendations to buyers. She wishes she had interesting hobbies to include in this bio.