Understanding how to calculate retained earnings is essential for business owners and investors alike, as it provides valuable insight into a company’s financial health and growth potential.
This post will guide you through the process of calculating your company’s retained earnings step by step to help you make informed decisions regarding your business’s financial performance.
Retained earnings formula
Since retained earnings is a company’s accumulated net income that is kept after paying out dividends to shareholders, you can find retained earnings with three factors:
- Beginning period retained earnings
- Net income (profit or loss)
- Dividends paid
Given that, the retained earnings equation is as follows:
How to calculate retained earnings
Here’s how to calculate retained earnings step by step:
- Start with the beginning balance of your retained earnings
- Add your net income for the most recent reporting period
- Subtract any dividends paid out of that net income
It’s that simple. Add your net income and subtract dividends paid to get the end balance of your retained earnings.
Example of retained earnings calculation
Let’s look at an example to see how the retained earnings formula works.
Company XYZ has reported figures for a three-month period ending February 28th, 2021 (figures are in thousands of dollars). While calculating retained earnings of this company, assume the beginning retained earnings balance is $0.
So plug the numbers from the example into the retained earnings formula:
Beginning period retained earnings + Net income (profit or loss) – Dividends paid
$0 + $35 – $15 = $20
Company XYZ’s retained earnings are $20.
Statement of retained earnings template
A statement of retained earnings template generally includes the following sections:
- Beginning Retained Earnings
- Net Income (or Loss)
- Cash Dividends
- Stock Dividends
- Ending Retained Earnings
Retention ratio
Retained earnings can also be reported as a percentage of total earnings, known as a retention ratio.
Here’s how you calculate the retention ratio:
If your company doesn’t make dividend payouts, the formula would be:
Retained Earnings / Net Income
The retention ratio is the opposite of the dividend payout ratio, which looks at the percentage of earnings paid to shareholders. You can find the dividend payout ratio by subtracting the retention ratio in decimal form from one.
Dividend Payout Ratio = 1 - Retention Ratio
How to interpret retained earnings calculations
Do you want high or low retained earnings? That depends on your company’s circumstances.
If dividends are rising at a proportionally larger amount each year compared to net income, the retention ratio will decrease. That’s an indicator the business is focusing less on growth (because more money is going to shareholders and less is being reinvested.)
Startups and smaller, growth-focused companies tend to have high retention ratios. Large companies that are already profitable and comfortable paying dividends will have a lower ratio.
Distributing dividends reduces retained earnings, whether paid in cash or stock. When a company pays dividends in cash, it results in a net reduction. And liquid assets used for cash dividends reduce the company’s asset value, which affects retained earnings.
Can you have negative retained earnings?
A negative retained earnings is a reflection of a company’s financial performance. It usually means that revenue is too low and expenses are too high. Companies also include non-cash expenses in their income statement such as depreciation as a strategy to lower the retained earnings account
From a reporting perspective, retained earnings are a vital connection between the income statement and the balance sheet, where they’re recorded under shareholders’ equity.
Notable considerations about retained earnings
Building up a retained earnings account may sound appealing, but you should keep in mind a few key points about the nature of retained earnings:
- Retained earnings might not provide meaningful insight to investors trying to determine a company’s health during a quarter or a year, as they need to compare figures over several years to determine a company’s performance.
- Fluctuating profits make retained earnings an uncertain source for investors to gauge a company’s performance.
- Some companies underestimate the opportunity cost of building up retained earnings, enabling them to invest in companies or opportunities.
Use automated tracking to process expenses with ease
Retained earnings provide you with insight into your cumulative net earnings. But several financial statements need to be prepared to calculate retained earnings. One of them is the income statement, and you’ll need to process expenses to put this statement together.
The simplest way to know your company’s financial position is with an expense management platform that tracks operational activities in one place.
BILL Spend and Expense simplifies the invoice-capturing process by doing all the hard work. All you have to do is review and approve. Find out how BILL can help you organize your financial data and save time.