A company can utilize profits in more ways than one. It can share the profits among the business owners and shareholders or reinvest the money back into the company.
No matter how the profits or retained earnings are used, this income needs to be calculated carefully. This article shows you the retained earnings formula with examples as well as its interpretation for your business.
Retained earnings are the net income you are left over with once you have paid out dividends to your shareholders. The earnings of a business may be either a positive figure (profits) or a negative figure (losses).
The amount of retained earnings of your company since its inception is a cumulative figure. Although you may register profits in the course of running your business, you will also make payouts from them.
For instance, you may pay dividends to your shareholders from your profits, also called retained surplus, positive earnings, or accumulated earnings.
But a company can also put aside a percentage of their positive earnings. This may be for several reasons, such as:
As a business partner or an owner of a small business, it is important to know how to calculate retained earnings. The formula is quite simple and goes as follows:
Return Earnings = Beginning Period Return Earnings + Net Income Less Cash Dividends and Stock Dividends.
In simple terms, retained earnings are the money that is left over after paying for cash and stock dividends.
Your retained earnings give you vital information on the surplus income available with your business. Alternatively, it may tell you if your business is running at a loss.
It is very easy to continue running a business without realizing that you are losing money regularly. It means that you are paying to run your business, and eventually, the losses will catch up with you.
By interpreting your retail earnings calculation, you can plan the future of your business and put it back on track.
In case your business is making profits, your retail earnings calculation tells you how much you can reinvest into areas like new hires and upgrading technology.
Once you have the particular number that represents your retained earnings, you need to understand it. By looking at the figure and the report that accompanies it, you get a snapshot of your business since it was formed.
That way, you can analyze the progress of your business over time to determine the amount of available capital.
You should look at these reports at least once every quarter. It will enable you to gauge the way your business is progressing and make projections on future performance.
Just like any business activity, you need to consider the long-term data with retained earnings calculations.
For example, let’s assume that there were major renovations to your office during the first half of the year. However, there were minimal expenses for the rest of the year.
If you looked at the data of only the first half, the figures would be inflated, but the figures in the second half would be less. Considering the period of the entire year, on the other hand, would reveal a healthy average.
Now that you have a fair idea of what retail earnings are and how they are calculated, let us simply it further to demystify the myth.
As we discussed above, the formula for retail earnings is:
RE = BP + Net Income (Profit or Loss) - C – S
We will break things down further by studying each component of the retained earnings formula.
If your company has accumulated any surplus money, that amount is noted at the start of the financial year. Some organizations may call this amount “beginning retained earnings.”
The main aim of the calculation is to arrive at a figure that represents your retained earnings. For calculating this figure, you need to apply the profits or losses of your company for that particular financial year.
You also need to subtract the amount that represents the total dividends paid out to your shareholders. The remaining figure that you get is your retained earnings.
Net income is the money that your company is left with after paying for all expenses during a particular fiscal year. The net income of your company reflects how well it did during that year.
Examples of expenses that your company would typically incur during a fiscal year are:
You would need to keep an accurate record of the year’s expenses throughout the year, which means spending considerable time and energy. Fortunately, a professional bookkeeping firm like Fincent can take care of these matters for you.
Finally, we come to the last couple of variables in the retained earnings formula – dividends. Dividends payable are the money that the board of directors of a company allocates to pay to shareholders. This money is considered a current liability.
The two types of dividends are cash payments and stock payments:
The payment of dividends will always reduce retained earnings. Your bookkeepers will subtract the value of dividends from your balance sheet to maintain an accurate figure of retained earnings. The extent to which dividends are paid out will affect the final figure accordingly.
If your company is focused on growth, then the amount paid out in dividends may be less. Sometimes, dividend allocation could be restricted to a minimum, or there could be none at all.
Now that you are clear about the concept of returned earnings and how it is calculated, let’s look at an example.
Alicia started her sound recording studio with some of her ex-classmates from business school. The services they provided were good and well-received by their clients.
During the first fiscal year of the company, they made a small but respectable profit. That first year, the partners only withdrew a monthly amount paid to each partner as salary.
The company was awarded some high-paying contracts during the second year. Their bookkeeper suggested that they pay out a percentage of the annual profits in the form of dividends.
Here’s how the calculations looked on paper:
They decided to pay shareholders $1,000 in dividends.
By applying the formula for retained earnings, the result was as follows:
$100,000 (BP) + $10,000 (NE) = $110,000
$110,000 - $1,000 = $109,000
The retained earnings for Alicia's company for that year were $109,000.
You may not always see positive figures in your company’s retained earnings calculation, as we saw in the case of Alicia’s company.
We always prefer a positive value with retained earnings. It reflects the cumulative surplus over time. But there are years when a negative figure may feature.
Known as “accumulated deficit”, this is an indication that appropriate action has to be taken to restore the company's financial health.
While calculating retained earnings, you may need to relate them to the market value to know how your company has applied retained earnings over time.
You need to calculate this figure over a few years. Take a note of the increase or decrease in your company’s stock price as compared to its net earnings.
Let us say there was an increase in your company’s stock price from $83.50 to $115.32. During the same period, your company's net earnings per share were $30, and $5 per share was paid out as a dividend.
To calculate the net earnings retained by your company, you need to subtract the dividends from earnings per share:
$30 - $5 = $25
Your company has retained $25 per share over five years. But your stock rose from $83.50 to $115.32, registering a rise of $31.82 (115.32-83.50).
Now, divide this difference by net earnings per share:
$31.82/ $25 = $1.27
This indicates that your company generated $1.27 of market value for each dollar of retained earnings.
Now you know what retained earnings are. But maintaining data to calculate and track your company's retained earnings can be a tedious and time-consuming process. After all, you were born to create, not to do bookkeeping.
Save time, money and energy by partnering with Fincent, a professional bookkeeping service that creates perfect books for you, so that you can attend to the more important aspects of running your business.
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