Retained earnings are like a running tally of how much profit your company has managed to hold onto since it was founded. They go up whenever your company earns a profit, and down every time you withdraw some of those profits in the form of dividend payouts.
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Here we'll go over how to make sure you're calculating retained earnings properly, and show you some examples of retained earnings in action.
The retained earnings formula is fairly straightforward:
Current Retained Earnings + Profit/Loss "“ Dividends = Retained Earnings
Your accounting software will handle this calculation for you when it generates your company's balance sheet, statement of retained earnings and other financial statements.
If you happen to be calculating retained earnings manually, however, you'll need to figure out the following three variables before plugging them into the equation above:
Let's say your company went into business on January 1, 2020. Your retained earnings account on January 1, 2020 will read $0, because you have no earnings to retain.
Now let's say that in January you earn $1,000 in net income (from your income statement) and don't issue any dividends.
That means that on February 1, your company's retained earnings will be $1,000:
Current retained earnings + Net income - Dividends = Retained earnings
$0 + $1,000 - $0 = $1,000
This makes sense: you earned $1,000 in profits, and retained all of them.
Now let's say that the business does really well in February, and you make an enormous profit that month: $10,000. You're doing so well that at the end of February, you decide to pay out $2,000 of those profits in the form of cash dividends to your shareholders (you, your mom and your aunt Karen). And remember, the beginning balance for retained earnings will be $1,000.
That means that on March 1, your retained earnings will be $9,000:
Current retained earnings + Net income - Dividends = Retained earnings
$1,000 + $10,000 - $2,000 = $9,000
Sometimes when a company wants to reward its shareholders with a dividend without giving away any cash, it issues what's called a stock dividend. This is just a dividend payment made in shares of a company, rather than cash.
Calculating retained earnings after a stock dividend involves a few extra steps to figure out the actual amount of dividends you'll be distributing.
First, you have to figure out the fair market value (FMV) of the shares you're distributing. Companies will also usually issue a percentage of all their stock as a dividend (i.e. a 5% stock dividend means you're giving away 5% of the company's equity). So you have to figure out exactly how many shares that is.
Put in equation form, the formula for retained earnings in a stock dividend is:
Current retained earnings + Net income - (# of shares x FMV of each share) = Retained earnings
Let's say that in March, business continues roaring along, and you make another $10,000 in profit. Since you're thinking of keeping that money for reinvestment in the business, you forego a cash dividend and decide to issue a 5% stock dividend instead.
Let's say your company has a total of 10,000 outstanding shares of common stock, and you determine that the fair market value of each share is $10. That means you would issue 500 shares in the dividend, each of them reducing retained earnings by $10:
Current retained earnings + Net income - (# of shares x FMV of each share) = Retained earnings
$9,000 + $10,000 - (500 x $10) = $14,000
This means that on April 1, retained earnings for the business would be $14,000.
Although they all have to do with the equity section of the balance sheet, working capital and shareholder's equity (also called stockholder equity, paid-in capital or owner's equity) are different from retained earnings.
Shareholder's equity measures how much your company is worth if you decide to liquidate all your assets. The formula for calculating it is:
Shareholders' Equity = Total Assets − Total Liabilities
Working capital is a measure of the resources your small business has at its disposal to fund day-to-day operations. To get it, you subtract all of your current liabilities from your current assets:
Working Capital = Current Assets − Current Liabilities
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