Retained Earnings: Definition, Formula, and Why It’s Important for Your Small Business

As a small business owner, juggling day-to-day business to-dos while keeping track of your business’s important financial information is no easy task. There are several metrics and numbers your business can use to gain insight into your financial standing, and retained earnings are one of them. Keep reading as we outline what retained earnings are, how to calculate them, and what they can tell you about your business.

What is retained earnings?

Next, we’ll answer “What are retained earnings?” The definition will help you better understand how it impacts your business. Typically, the net profit your business brings in is allocated in two ways: (1) as distributions or dividends to shareholders and stakeholders or (2) kept within the business to promote growth.

Retained earnings (RE) refers to the portion of your net income that remains after dividends have been paid to shareholders. These remaining profits are instead destined to be reinvested back into the business. Usually, when your business sees a net profit, your books will show an increase to RE as well. When net profits go down, there is often less RE to put back into the business to support growth.

Where to find a statement of retained earnings?

Retained earnings will appear on the liability side of your balance sheet under shareholder’s equity. They are an important source of self- or internal financing. They are often used to cover working capital, fixed asset purchases, or paying off debt.

Here are some factors that could influence your RE:

• Profitability – The more profit a company generates, the more potential it has to increase its retained earnings. As long as those profits are not entirely distributed as dividends, some may become RE.
• Company age – Newer companies may have lower RE simply because they haven’t had as much time to accumulate profits. Older, established companies often have higher RE due to years of profitability and prudent financial management.
• Dividend plan – The amount a company decides to pay out as dividends directly reduces retained earnings. Companies that distribute more dividends retain less profit for reinvestment into the organization.
• Financial management – A solid money management plan includes retained earnings as part of your company’s overall financial strategy. Don’t forget to account for them!
• Seasonality – Seasonal businesses may experience fluctuating profits, preventing consistent retained earnings throughout the year. It’s wise for such businesses to plan for off-peak periods by saving more into RE during peak seasons. This helps ensure your business has resources to grow and can maintain its financial health throughout the year.

Is retained earnings a debit or credit?

Retained earnings are thought of as credits, because they increase with each credit entry. They decrease with a debit entry.

Retained earnings formula

The retained earnings equation is used to calculate the balance in the RE account at the end of an accounting period. The retained earnings formula is:

RE = BP + Net Income – C – S

Where:

• BP = Beginning Period RE (The BP retained earnings is the closing balance of the RE account in the previous account period).
• C = Cash dividends
• S = Stock dividends
• Note that if you broke even or lost money, your net income may be zero or a even negative.

Breaking down the formula: How to calculate retained earnings step-by-step

To calculate the retained earnings for a given accounting period for your company, you’ll plug in the required numbers into the formula above. Let’s look at an example calculation for a fictional company called ABC Corp:

• Gather the necessary information: The first step to calculating retained earnings to make sure all the required information for the formula is accessible. For ABC Corp, let’s assume the following information:
  • BP Retained earnings: $20,000 (This will be recorded in the shareholder’s equity section of your balance sheet.)
  • Net income: $8,000 (Your net income will be found on your income statement, often called the “bottom line”.)
  • Dividends paid (cash and stock): $2,000 (The gross on dividends paid can be found on your cash flow statement.)
    • Dividends paid: These are payments made to shareholders from a corporation’s profits. They are usually given in the form of cash or additional shares.
    • Distributions: This term is broader and can refer to any payment made to owners or investors. For instance, partnerships, LLCs, and S corporations often use the term “distribution” to describe payments made to their owners for things like their salary.
    • NOTE: Dividends are a type of distribution. Not all distributions are dividends. The terms used can vary depending on the type of business entity.
• Plug the numbers into the retained earnings formula: For our fictitious company ABC Corp, the formula would look like this:
  Retained earnings = $20,000 (BP) + $8,000 (Net Income) – $2,000 (Dividends)
• Calculate!
              RE = $20,000 + $8,000 – $2,000 = $26,000
              So, ABC Corp’s retained earnings for the given period is $26,000.

What’s the purpose of retained earnings?

Retained earnings provide a valuable connection between your income statement and balance sheet, giving you a holistic picture of your business’s financials. They are sometimes called “earnings surplus,” representing a reserve of funds. How a company chooses to use this surplus varies on the type of business and its needs, but here are some common purposes:

• Paying off existing debts
• Funding business growth – hiring new employees, improving existing infrastructure, buying new equipment, etc.
• Funding new products and launches
• Dividend distribution – distributed fully or partially among the business shareholders and/or owners
• Funding possible mergers, acquisitions, and partnerships
• Share buybacks – if seeking to improve the value of company stock
• Protecting against unforeseen circumstances – build a rainy day fund to cushion against economic downturns, surprise emergencies, cash flow shifts, etc

Negative vs high retained earnings

Negative retained earnings for a company generally indicate that the company has experienced consistent losses or large dividend payouts. High, or positive, RE have more room for interpretation. High RE could suggest financial strength and that your company is profitable. It could also suggest, however, that your company should consider paying more dividends to its shareholders.

Retained earnings and management

As you can see, there are a lot of factors that influence the decision of whether to retain the earnings or distribute them. So, who makes that decision? Usually, the decision is left to company management. However, this decision can be challenged by shareholders. Management and shareholders may want the company to keep its profit or distribute it for different reasons.

Management is generally better informed about the company’s business and its position in the market, and they may have high-growth projects in mind. Management may be confident that reinvesting the money into the company will create more value for shareholders by generating higher returns.

However, when there is surplus income, some shareholders may expect that there will be some sort of regular income in the form of dividends. Paying off high-interest debt, however, may be preferred by both shareholders and management. It’s likely that both management and shareholders would want to retain the earnings if they were aware of profitable investment opportunities. This decision is complex, and a company’s management often takes a balanced approach to making it.

Is retained earnings an asset or type of equity?

Retained earnings is a type of equity. As mentioned above, it is reported in the shareholder’s equity section of your balance sheet. RE can be used to purchase assets like inventory, equipment, or other investments.

Retained earnings vs revenue and profits

How is retained earnings different from revenue and profits? It’s easy to get these terms confused as they all show a piece of your company’s financial puzzle. Revenue is at the top of your income statement, often referred to as the “top-line” number of your business’s financial performance. Revenue, or gross sales, is the money that a company generates during a period before operating expenses and overhead costs are subtracted. The main difference between RE and profits is that it subtracts dividend payments whereas profits don’t.

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Frequently Asked Questions – Retained Earnings

Q: What are retained earnings in simple terms?
A: Retained earnings are the portion of your business’s net profit that remains after paying dividends to shareholders. Instead of being distributed, these profits are reinvested back into the company to support growth, pay off debt, purchase equipment, or fund new projects. They appear on the liability side of your balance sheet under shareholder’s equity

Q: How do you calculate retained earnings?
A: Use the formula: RE = BP + Net Income – C – S, where BP is beginning period retained earnings (from the previous period’s closing balance), Net Income is found on your income statement, C is cash dividends paid, and S is stock dividends. For example, if BP is $20,000, net income is $8,000, and dividends are $2,000, your RE would be $26,000

Q: Are retained earnings an asset or equity?
A: Retained earnings are a type of equity, not an asset. They are reported in the shareholder’s equity section of your balance sheet. While RE can be used to purchase assets like inventory or equipment, they themselves represent accumulated profits that belong to the shareholders

Q: What’s the difference between retained earnings and revenue?
A: Revenue is the total money your company generates during a period before any expenses are subtracted – it’s the “top-line” number on your income statement. Retained earnings, however, are calculated from net profit (after expenses) minus dividend payments, representing accumulated profits kept within the business rather than distributed to shareholders

Q: What do negative retained earnings mean for a business?
A: Negative retained earnings generally indicate that your company has experienced consistent losses over time or has paid out large dividends that exceeded accumulated profits. This suggests the business may be struggling financially or has made significant distributions to shareholders that depleted the RE account

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This article is for informational purposes only. The content may not constitute the most up-to-date information and should not be construed as legal advice.