Retained Earnings Formula

Retained Earnings formula calculates cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company and it is calculated by subtracting the cash dividends and stock dividends from the sum of beginning period retained earnings and the cumulative net income earned.

Thus, it is that part of the profit that the company retains with itself as a source of funds. They may be used for the expansion of investment and are reported in the balance sheet under the equity section. It may be negative or positive.

Retained Earnings is very important as it reports how the company is growing with respect to its profit.

An investor can make an idea through trend analysis whether the company is retaining its profit or its paying part of profits as dividends.

As per the equation, statement of retained earnings formula depend upon the previous year figures.

The figure may be positive or negative, depending upon inputs in the formula. If the company suffered a loss last year, then its beginning period RE will start with a negative.

Similar to the second input is current year profit or loss, which may be positive or negative depending upon how the company performed.

In case a company is dividend-paying, even this could lead to negative retained earnings formula on the balance sheet if the dividends paid are significant.

The method of calculating the above is given below in detail, along with the statement of retained earnings formula.  

Retained Earnings (RE) = Beginning Period RE + Net Income (Loss) – Cash Dividend – Stock Dividend 

Where,

• Beginning Period RE can be found in the Balance sheet under shareholders’ equity.
• Take Net Income / (Loss) from Profit and Loss Statement.
• Cash Dividend, if paid any, can be figured out from financing activity from cash flow statements.

Let us go through some examples to understand the concept of statement of retained earnings formula.

Example #1

Below given is the financial statement extracted from ABC company. Do the Calculation of the Retained Earnings using the given financial statements.

Given,

• Beginning Period Retained Earnings = $0
• Net Income from the Income Statement = $70,000
• Cash Dividend = $5,000

So, the calculation of retained earnings formula on balance sheet will be as follows –

Retained Earnings will be-

Therefore, Retained Earnings =65000

Example #2

Let us now calculate the retained earnings of Colgate using the formula that we learned earlier.

Below is the snapshot of shareholders’ equity items of Colgate.

Retained Earnings at the beginning period = $18.861 million

Below is the snapshot of Colgate's Income Statement.

We note that Colgate's Net Income is $2,441 million.

We also note that Colgate’s Dividends were $1380 during the period.

• Ending Retained Earnings formula (2016) = Retained Earnings (2015) + Net Income (2016) – Dividends (2016)
• Ending Retained Earnings formula = 18,861 + 2441 – 1380 = $19,922 million

Some of the uses of this part of profit that is kept aside by the business is given below.

• Retained Earnings Formula calculates the current period Retained Earning by adding previous period retained earnings to the Net Income (or loss) and then subtracting the dividends paid during the period.
• Whenever a company generates a surplus, it always has an option to pay a dividend to its shareholders or retain it with itself.
• Further, if the company is making huge profits, then its shareholders would expect regular income in the form of dividends for risking their capital.
• If the company expects more investment Opportunities and will earn more than its cost of capital, then it would intend to retain the funds instead of paying dividends.
• And if a company thinks the expected returns from opportunities will yield low returns, then it will wish to pay them as a dividend to its shareholders.
• Among a few factors, thoughtful consideration could be given to trends and past performance as to how efficiently retained earnings were utilized by the company while looking for long term value investments or dividend payouts.

Let us look at the benefits of the formula:

• Determine dividend – The retained earnings formula accounting is used in companies to calculate how much money they can afford to pay as dividend and and how much will remain back in the business.
• Design growth strategy – Investors look for the retained earnings or calculate it for the purpose of analysing how much investment is possible for the business. The higher the value of retained earnings, the more potential the business has to take up larger investments for expansion and growth.
• Indicates financial strength – This accumulated retained earnings formula calculates the part of profit that is still lying with the business after paying off the liabilities. Thus, if this figure is high, it shows that the company is financially strong.
• Identify areas of improvement - It helps the company identify the areas that need attention, upgradation and improvement and has a potential to earn revenue.

The formula is a very important tool for assessing the financial performance of the business. But it also has some limitations as follows:

• Lack of details – The formula does not calculate the individual factors that contribute in the earnings, which might be positive or negative.
• Manipulation – There is always a possibility of manipulation by the company officials in the form of inflated figures so that the overall financial performance of the business looks good to the investors and other stakeholders.
• Does not show the cash flow – The accumulated retained earnings formula does not show the cash flow figures. It is to be noted that cash flow is a critical criterion for any business because it is used to finance day-to-day operations. A company may have good retained earnings, but it isn't easy to survive in the long run if cash flow is low.

Thus, while making an analysis about the financial condition of the company, it is necessary to know both the benefits and limitations of the calculation so that informed decision can be taken regarding investment.