How To Calculate Retained Earnings And Why It’s Important

March 26, 2024
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Calculating retained earnings isn’t just about crunching numbers to determine profits. It’s about understanding a company’s financial story, from past struggles to potential growth.

Here’s how to calculate retained earnings, why they’re important, and what they tell you.

What Are Retained Earnings?

Retained earnings are the funds left over when a company shares profits with shareholders by issuing dividends. A company’s retained earnings add up over time. This figure reflects the total historical profits rather than profits from one quarter.

Investors look at a company’s retained earnings to check for growth. This growth indicates businesses have more funds available for operations than they need. 

How much profit you put back into the company or pay shareholders impacts retained earnings. Management might choose to pay out only a small percentage during growth periods. This leaves more funds to reinvest.

You can use retained earnings for several reinvestment goals:

  • Expanding manufacturing. This includes buying more equipment and increasing factory output.
  • Improving existing products and services
  • Bringing new offerings to market. Do this with research and development.
  • Growing the sales team by adding more staff to increase revenue
  • Repurchasing company shares. This enhances shareholder value.
  • Developing and releasing new products and services to increase profit

Why Are Retained Earnings Important?

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Lots of retained earnings mean a company can cover more than the basics and keep growing. These basics include expenses, payments, and dividend payouts. As mentioned, increasing retained earnings means the company has more money left over, which it can use to grow the business further.

But an unchanging or declining retained earnings growth rate is a bad sign. It means the company is struggling to stay afloat.

Companies doing well today became big by using their retained earnings wisely. Here are some examples:

  • Amazon started as a place to buy books online, but it grew into the biggest online store in the US. It then used its profits to create services like cloud computing.
  • Starbucks used the money it made to open lots of stores in the US and around the world. It also made new drinks like the pumpkin spice latte to get more customers.
  • Apple used retained earnings to invest in product research and development. The launches of products like the iPod and iPhone propelled the company to the tech industry’s highest ranks.

When a company has a lot of retained earnings, it can draw interest from investors. They usually look at how much money the company has saved up and how fast it’s growing before deciding to invest.

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How To Find Retained Earnings on a Balance Sheet

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The first step to analyzing a business’s financial health is knowing where to look. Retained earnings appear on the last line of a company’s income statement, also known as a profit and loss statement. The figure will also be in the shareholder equity section of its balance sheet. Companies might also keep retained earnings sheets that record them over several years.

How To Calculate Retained Earnings

Calculating retained earnings requires just a few figures and some addition and subtraction. Use the following steps:

  1. Find the starting balance of your retained earnings.
  2. Add net income for the most recent reporting period.
  3. Subtract dividends paid out for the most recent reporting period.

We can summarize the process with this formula:

Beginning retained earnings + Net income – Dividends paid out = Retained earnings

Increasing retained earnings shows potential for growth and healthy finances. Declining retained earnings suggest trouble.

In addition to being used in the formula for retained earnings, net income helps assess profitability. And looking at total dividends paid out helps determine reinvestment versus shareholder payouts.

Here’s an example. Let’s say there’s a publicly traded computer chip manufacturer called ChipCo. The company has $500 million in retained earnings at the beginning of the year. ChipCo is interested in the growth of the AI industry, so they choose to pay minimal dividends to investors. Instead, they focus on growing capacity to supply computing power to AI companies. If ChipCo earns $50 million in net income and pays out $5 million in dividends, we can calculate retained earnings for the year as follows:

$500 million in beginning retained earnings + $50 million net income – $5 million in dividends paid out = $545 million in retained earnings

The following year, new AI technology creates a demand for computing power. Chips are in short supply globally. ChipCo’s smart reinvestment of retained profits earns $200 million in net income. They choose to pay out $25 million in dividends. We can calculate retained earnings for that year:

$545 million in beginning retained earnings + $200 million net income – $25 million in dividends paid out = $720 million in retained earnings

A comparison shows that ChipCo increased retained earnings by 30%. They also increased dividend payouts. This proves to investors that the company is on the right track.

Comparing Net Income to Retained Earnings

Net income or net profit is an important part of a company’s retained earnings. You can find it by subtracting a company’s expenses from its total revenue for a specified period. Dividends don’t factor into the calculation.

Net income is a useful starting point for looking at a company’s profitability, but it doesn’t show the whole picture. It’s calculated for specific time periods, so it’s subject to large fluctuations. These could be from seasonality, economic cycles, and one-off gains or losses. These differences can make it hard to gauge a company’s financial health.

But retained earnings are a cumulative metric. It smooths out fluctuations by showing trends over time. This makes it more reliable for long-term insights about a company’s growth and trajectory.

Plus, consistently paying out dividends gives retained earnings a steadier value than net income. 

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Key Points To Remember About Retained Earnings

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Retained earnings show if a company is making money and can grow. Remember these points when using it to check a company’s finances:

  • Retained earnings are useful, but don’t rely on them alone for decisions. Look at other things like cash flow, debt levels, and the profit the company makes from its investments. This gives you a clearer picture of the company’s financial health.
  • Small businesses see more changes in their retained earnings than big ones. Seasonality, one-time expenses, and business changes all impact profits. Small business owners should look at retained earning trends over several years. This gives a clearer picture of potential long-term goals.
  • Some companies pay dividends every year. Others might change this suddenly. This can make it hard to see trends because of ups and downs.
  • Small businesses usually rely heavily on reinvesting profits, not outside funding. A retained earnings balance shows how much the company could put toward growth. Track retained earnings closely to see if the company is saving enough to support its goals.

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