What Are Retained Earnings?
Retained earnings refer to a company’s net profit after paying out dividends to shareholders. This amount gives companies clarity on how much money their business has after paying off all their dues, including the share of the investors.
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For eg:
Source: Retained Earnings (wallstreetmojo.com)
When recording details in the retained earnings statements, the values change as and when there is a change in the revenue and expense accounts. The value decreases in case companies incur losses and pay dividendsDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more, while it increases when the company records new profits.
Table of contents
Key Takeaways
- Retained earnings are defined as cumulative profits earned by the company after distributing the dividend or other required portions to its investors.
- These can be used for reinvestment purposes.
- Positive net income doesn’t necessarily result in positive retained earnings. The latter can be negative even if the former is positive or vice-versa.
- Retained income at the beginning of a year, net income, and dividends are three components that help calculate retained profits.
Retained Earnings Explained
Retained earnings, as the name suggests, are the sum that a company retains after meeting all its financial liabilities, including the payment of the shareholders. This retained income is the amount companies use for reinvestment, which means utilizing the money back into the business. These earnings form a part of the shareholders’ equity section of the balance sheet.
As the firms pay a dividend to the shareholders despite losses, the retained sum decreases. On the other hand, when they earn profits, the retained sum increases. Its value keeps changing depending on the increase and decrease in the revenue and expense figures.
Components
The meaning of retained earnings is clearer when the components that help calculate the same are thoroughly studied. The elements that help derive the retained income figures are – retained income in the beginning, net profit or loss, i.e., the net income, and applicable share of dividends.
- Beginning retained earnings is any accumulated surplus recorded at the beginning of a financial year. The amount depends on the companies’ profits, losses, or any surplus given to shareholders in the form of a dividend.
- Net income is a company’s total earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read more in a financial year. It is the difference between the company’s expenses and revenue. If the revenue is more than all the expenses, the company earns a net profit; else, it’s a loss for that particular year. Net income is the company’s bottom line in its income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more.
- The dividend is a portion of earnings that a company distributes to the shareholders. It is the return or reward for their investment in the company. The dividend can be in the form of cash payments or stock payments, also called bonus issues.
Retained Earnings in Video
Equation
Companies calculate retained earnings at the end of a financial year by adding the net income to the company’s retained profits as recorded at the beginning of that year and subtracting the dividend from the resultant.
The equation used for retained earnings calculation is:
Retained Earnings = Retained Earnings in the beginning + Net Income – Dividend
Where,
- Net income is the difference between the total expenses and the total revenue. The expenses include material costs, general and administrative expenses, salaries of employees, depreciation, amortization, interest payable on debt, and taxes.
- A dividend can be the value of the stocks, the cash value, or the sum of both values.
How To Calculate?
Suppose the beginning retained income of the company is $150,000, and the profit earned is worth $10,000 (Net Income). Plus, the company board decides to pay $1,500 as a dividend to shareholders.
Now, the retained profits calculation at the end of the financial year will be as follows:
Retained Earnings = Retained Earnings in the beginning + Net Income – Dividend
=$(150,000+10,000-1,500)=$158,500
Thus, the retained income for the company that it can use back into the business is $158,500.
Example
Let us check the balance sheet of Colgate, displaying the retained earnings of 2015-16, and learn to locate it on the balance sheet.
Beginning RE (2015) = $18,861 million
The net income of Colgate in 2016 was $2,441 million.
Dividends paid are $1,380 million.
Ending Retained Earnings = 18,861 + 2441 – 1380 = $19,922 million
Thus, the final retained income is as follows:
Advantages & Disadvantages
While calculating the retained profits offers the owners clarity on the finances they currently have to reinvest in the business; there are a few cons that one must also be aware of:
| Pros | Cons |
|---|---|
| A permanent source of finance that stays with the company | No assurance of the returns on investment. |
| Offers huge flexibility for use as it is the firm’s internal money | Chances of tax evasion |
| This leads to an increase in the share value of the company | Investors are less impressed as the dividend is limited, given the company’s retention of its own profits |
| Businesses can use the money back into the business |
Retained Earnings vs Net Income
The two terms are synonymously used, but they are completely different. So, let us have a look at the differences between the two:
- Net income is the difference between a firm’s total revenue and expenses. At the same time, retained earnings are the sum the company has after it deducts the dividend liabilities and commitments from the net income.
- Therefore, net income becomes a significant component while making retained earnings calculations.
- Even if a net income is positive, it doesn’t signify a positive retained profits sum. There are times when the latter is negative, even when the former is positive, causing accumulated deficits for the firm.
Frequently Asked Questions (FAQs)
These earnings take the credit side. This is because it forms a part of the shareholders’ equity section of the balance sheet. However, if the value of these profits is negative, they are considered a debit balance. In short, the increasing retained sum is a credit entry.
These are not an asset themselves. However, the finances retained after the dividend payment can be used to buy assets or resources as part of business investment. For example, the funds can help buy the business’s inventory, equipment, etc.
Yes, these can be negative. When the value is negative, it signifies the poor financial health of the firm. This happens when the company incurs significant losses in the previous year. It is often assumed that the retained profits are negative only if the net income is negative. But there are instances where the net income is positive, but the retained income is still negative.
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