Are you pouring over accounting but not sure what retained earnings are or what they mean for a business? Don’t despair. In this article, we cover what the term means, why they’re important and how an accountant can calculate them.
What are retained earnings?
Retained earnings are the profit that a business generates after costs such as salaries or production have been accounted for, and once any dividends have been paid out to owners or shareholders.
They’re sometimes called retained trading profits or earnings surplus. These phrases help further explain what they are. On the balance sheet they’re considered a form of equity—a measure of what a business is worth.
What a business does with retained earnings can mean the difference between business success and failure, especially if the business is looking to grow.
Why retained earnings are important for a small business
Here’s where retained earnings prove vital: business owners can choose to plough that money back into the business or use it to pay off balance sheet debts.
Essentially, retained earnings can finance a business so it can do new things with no need to go through an application process for a loan, and with the cash instantly available and with no questions asked. Seen in this light, it has been said that retained earnings are by default the most widely used form of business financing.
If a business is small or in the early stages of growth, you might think that using retained earnings in this way makes complete sense. And you’d be right.
In fact, some very small businesses—such as sole proprietors or basic partnerships—might not even account for retained earnings and instead may simply consider it part of working capital. But it’s worth recording retained earnings in accounting anyway, for various reasons.
For example, a business might want to create a retained earnings account to save up for some new equipment or a vehicle—something known as capital expenditure (or capex). And there are other reasons to take retained earnings seriously, as we’ll explain below.
How do retained earnings affect a small business’ financial statements?
Most businesses include retained earnings as an entry on their balance sheet. The figure appears alongside other forms of equity, like the owner’s capital. However, it differs from this conceptually because it’s considered to be earned rather than invested.
Retained earnings are cumulative on the balance sheet. The figure from the end of one accounting period is transferred to the start of the next, with the current period’s net income or loss added or subtracted.
Because of this, the retained earnings figure doesn’t necessarily communicate much about the business’ success in the here and now. But it’s a clear general indicator of business health and is definitely something investors look at.
Retained earnings don’t appear on the income statement, also known as a profit and loss statement. The income statement will list a net income figure, which might seem to be the same as retained earnings but isn’t. The net income contributes to retained earnings but, as mentioned, retained earnings are cumulative across accounting periods, subject to dividends being taken out, and accounted for as an asset.
A forecast statement might include retained earnings if this is something a business would like to project to measure the growth of the company alongside sales.
This might be a requirement if a business wants to attract investment, for example, because it’s a useful indicator of profitability across financial periods and shows business equity.
How to account for retained earnings
Don’t be fooled: retained earnings are not the same as the business’ bank balance. A bank balance will rise and fall with the company’s cash flow situation (e.g. received payments and spending), but the retained earnings are only affected by the current period’s net income/loss figure. And nor are the retained earnings the same as the cash asset figure.
Remember that retained earnings equals equity, and so should not appear anywhere in the assets and liabilities parts of the balance sheet.
Are retained earnings the same as reserves?
The reserve account is drawn from retained earnings, but the key difference is that reserves have a defined purpose, like paying down an anticipated future debt.
Reserves appear in the liabilities section of the balance sheet, while retained earnings appear in the equity section. It’s also possible to create a retained earnings statement, alongside the regular balance sheet and income statement/profit and loss.
This helps investors in particular get a snapshot view of the profitability of a business. Usually, the retained earnings statement is very simple and shows the calculations as described below in the next section.
How accountants calculate retained earnings
Calculating retained earnings on a balance sheet is very simple. Accountants typically use a basic accounting formula:
Retained earnings = Opening retained earnings + net income/loss – dividends
Let’s look at this in more detail to see what affects the retained earnings account, assuming the goal is to create a balance sheet for the current accounting period. Here, we’ll see how to calculate retained earnings for the end of the third quarter (Q3) in a fictitious business.
We start by looking to the Q2 balance sheet. We need the final retained earnings figure from this. Let’s say it’s $10,000. If the business is brand new, then the starting retained earnings figure will be $0.
Assuming the business isn’t new, deduct from the retained earnings figure any dividends that the owner wants to pay from Q2 to themselves, or other owners of the business, or shareholders. Let’s say they decide to take $3,000 as a dividend. Therefore, the retained earnings figure will now be $7,000.
Add this retained earnings figure of $7,000 to the Q3 balance sheet in the retained earnings section under the equity section.
Finally, add the current net income/earnings figure, listed on the Q3 income statement/profit and loss, to the retained earnings figure for Q3. If you’re using a spreadsheet, you might create a formula that automatically does this. To carry on our example, if the income statement/profit and loss shows net income as $5,000 for Q3, then the closing retained earnings figure on the balance sheet for the Q3 period is $12,000 (that is, $7,000 + $5,000 = $12,000).
As far as financial matters go, retained earnings might not seem important for smaller for newer businesses. But it’s vital to at least gain an understanding of what it means, even if it’s not yet directly being accounted for (for example, if the business accounting doesn’t really get much beyond a profit and loss statement).
Knowing and understanding the retained earnings figure can help with business growth. But beyond that, those who want to invest in a business will certainly expect the owner or manager to understand its value because they’re not just investing in the business; they’re investing in them too. And if they aren’t taking care of basic accounting matters, then it could be viewed as a sign of a poorly-run operation.
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