Everything You Need to Know about Retained Earnings
Retained earnings might sound complicated, but the concept is easy: it’s the part of profits a company keeps instead of paying out to shareholders. Let’s understand what they are, why they matter, and how they work.
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What Are Retained Earnings?
Retained earnings are the accumulated profits that remain in a business after paying dividends. These funds are kept for use in future growth, paying off debt, or other company needs. Over time, these retained profits build up and are recorded under shareholders’ equity on the balance sheet.
Why Retained Earnings Matter
Retained earnings are essential because they show how much profit a company has reinvested back into the business. They’re crucial for evaluating financial strength, planning future spending, or convincing lenders and investors of stability.
How to Calculate Retained Earnings
You can calculate retained earnings using a simple formula:
Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings
Some versions also include stock dividends:
Beginning Retained Earnings + Net Income – Cash Dividends – Stock Dividends = Ending Retained Earnings
For Example:
Beginning retained earnings = $100,000
Net income for the year = $20,000
Dividends paid = $5,000
$100,000 + $20,000 – $5,000 = $115,000 retained earnings at year-end.
Impact of Net Income and Dividends
- Net Income increases retained earnings—it’s the profit added each period.
- Dividends, whether cash or stock, reduce retained earnings because they distribute profits to shareholders.
Retained Earnings vs Net Income: Key Differences
Net income (or net profit) is the profit earned in a single period; it’s like a snapshot. Retained earnings, however, are cumulative; they represent what’s left over after years of profits and dividend payouts.
Think of net income as the water flowing into a tank, and retained earnings as the level of water in that tank over time. The two are linked, but not the same.
Statement of Retained Earnings
Purpose of the Statement
This statement shows how retained earnings have changed over a period, tracking beginning balance, net income, dividends, and ending balance.
Factors That Impact Retained Earnings
- Net Profit or Loss: Profits increase retained earnings; losses decrease it.
- Dividend Distribution: Cash or stock dividends reduce the balance.
- Share Repurchases and Issuance: Buying back shares or issuing new ones can impact how retained earnings are used or spread across equity.
- Positive vs Negative Retained Earnings: If expenses and dividends exceed profits, retained earnings can go negative—called a deficit.
Conclusion
Retained earnings are the build‑up of profits kept in the business over time. By tracking them alongside net income and dividends, you get insight into how a company finances its growth and rewards shareholders. Regularly checking this balance helps guide smart business decisions and keeps financial health clear.
I am a Chartered Accountant with over 20 years of experience and a finance content writer. I focus on educating people about finance and taxation. I have written many blog posts on finance, taxation, trading, and investment on the BUSY website. My goal is to increase financial understanding by making complex concepts easier to grasp and to support educational programs in India.
Frequently Asked Questions (FAQs)
- What are retained earnings?Their profits are not paid out as dividends; instead, they are kept in the business and recorded in equity.
- How to calculate retained earnings?Use: Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings.
- What is the Statement of Retained Earnings?It’s a report showing how retained earnings changed during a period, listing beginning balance, net income, dividends, and ending balance.
- Retained earnings vs net income?Net income is the profit made in one period. Retained earnings are the total profits kept in the business over time after dividends.
