Retained Earnings: Understanding Its Importance in Business

1 minutes reading time
Published 13 Sep 2023

Every business, from a small startup to a multinational corporation, has to deal with finances. Similarly, every investor, whether big or small, must value businesses to make informed investment decisions. One often overlooked yet highly significant financial component is "retained earnings". In this article, we'll delve deeply into what retained earnings are, how to calculate it, and its importance in both business and investing.

Key Insights:

  • Retained earnings are the cumulative net earnings a company keeps after paying dividends, acting as its 'savings' or 'reinvestment fund'.

  • The retained earnings formula encompasses the beginning balance, net income/loss for the period, and dividends paid out.

  • Consistent growth in retained earnings signals a company's profitability and sound financial management.

  • For businesses and investors, understanding retained earnings is vital to evaluate a company's financial health and the potential for profit distribution.

What is Retained Earnings?

Retained earnings are essentially the cumulative net earnings of a company that are retained, rather than distributed as dividends to its shareholders or owners. Think of it as the 'savings' or 'reinvestment fund' of a company. After all operational and financial expenses are paid, and dividends are distributed to shareholders, whatever profit remains gets added to the retained earnings of a company.

Retained Earnings Formula

Calculating retained earnings isn't complex. The retained earnings formula is:

Retained Earnings at the End of the Period = Retained Earnings at the Beginning of the Period + Net Income/Loss for the Period − Dividends paid out

How to Calculate Retained Earnings: A Brief Walkthrough

  • Determine the starting balance: This would be the retained earnings at the beginning of the accounting period. It can be found on the company's balance sheet under shareholders' equity.

  • Add net income: This is the profit the company made during the accounting period. It can be found on the income statement.

  • Subtract any dividends: If the company distributed dividends, subtract this amount. If not, this step can be skipped.

The Statement of Retained Earnings

Companies often present a "statement of retained earnings" to provide a clear picture of how these funds have changed over an accounting period. It bridges the gap between two consecutive balance sheets, detailing the beginning balance of retained earnings, the additions or subtractions due to net income or losses, and the ending balance after accounting for dividends.

Is Net Profit the Same as Retained Earnings?

No, net profit and retained earnings are not the same. Net profit (often referred to as net income) is the amount left after all the expenses, taxes, and costs have been deducted from a company's total revenue. Retained earnings, on the other hand, represent what is left from net income after paying out dividend to shareholders.

Why are Retained Earnings Crucial for a Business?

Retained earnings are essential for several reasons. First, these earnings can be reinvested in the business for purposes like expansion, research, debt repayment, or other operational activities. Secondly, a consistent growth in retained earnings is a sign of profitability and indicates good financial management. Lastly, in times of financial need, a company can tap into its retained earnings rather than taking on debt or looking for external investors.

In summary, retained earnings represent the accumulated net earnings a company retains after paying dividends, functioning as a business's savings or reinvestment fund. They are determined by assessing the beginning balance, adding net income, and subtracting dividends. These earnings provide insight into a company's financial health and serve as a crucial resource for reinvestment and emergency funding. Understanding them is essential for both businesses and investors to gauge a company's financial position and the potential profit returned to shareholders.