Your retained earnings are the profits that your business has earned minus any stock dividends or other distributions. It can be a clearer indicator of financial health than a company's profits because you can have a positive net income but once dividends are paid out, you have a negative cash flow.
In terms of financial statements, you can find your retained earnings account (sometimes called Member Capital) on your balance sheet in the equity section, alongside shareholders' equity. In rare cases, companies include retained earnings on their income statements.
Your bookkeeper or accountant may also be able to create monthly retained earnings statements for you. These statements report changes to your retained earnings over the course of an accounting period.
The retained earnings formula is simple and comprised of three parts:
Beginning Retained Earnings + Profit/Loss "“ Dividends = Retained Earnings
Say you just started a business. Your beginning balance of retained earnings would be $0. If your amount of profit is $50 in your first month, your retained earnings are $50 for the current period.
Beginning Retained Earnings = $0
Profit/Loss = $50
Dividends = $0
$0 + $50 - 0 = $50
Here's a more complex example. To raise capital early on, you sold common stock to shareholders. Now your business is taking off and you're starting to make a healthy profit which means it's time to pay dividends.
Once your cost of goods sold, expenses, and any liabilities are covered, you have to pay out cash dividends to shareholders. The money that's left after you've paid your shareholders is held onto (or "retained") by the business.
Let's use the retained earnings from the example above as our starting point.
Beginning Retained Earnings = $50
Profit/Loss = $10,000
Dividends = $2,000
$50 + $10,000 - $2,000 = $8,050
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While your bottom line and retained earnings are related, they are distinctly different.
There may be times when your business has a positive net income but a negative retained earnings figure (also called an accumulated deficit), or vice versa. Your net income is what's left at the end of the month after you've subtracted your operating expenses from your revenue. Retained earnings are what's left from your net income after dividends are paid out and beginning retained earnings are factored in.
Made $50,000 in revenue and have $40,000 in expenses? Your net income for that month is $10,000. However, say you have two shareholders and you gave each of them $6,000 in dividend payouts that month. If we go back to our original equation, we can see that we're left with a negative retained earnings figure:
Beginning Retained Earnings + Profit/Loss "“ Dividends = Retained Earnings
$0 + $10,000 "“ $12,000 = -$2,000
Business owners use retained earnings as an indication of how they're saving their company earnings.
If you're starting to see higher profits but not sure what to do with it, do a quick check on your retained earnings balance. If this number isn't as high as you'd like (and if your business is relatively young), your safest bet is to keep these profits in the business and hold off on paying out a large amount of dividends. If your company ever sees a reduction in operations, and starts operating at a net loss, your retained earnings can carry you through.
Have a healthy net income and retained earnings? Now might be the time to use some retained earnings for reinvestment back into the business. If you have a booming ecommerce company, you might need to upgrade to a bigger warehouse or purchase a new web domain. These are called capital expenditures because they bring long term value and are outside your regular operating expenses, they're a great use of your retained earnings.
Further reading: Statement of Retained Earnings (A Complete Guide)
Your company's balance sheet may include a shareholders' equity section. This line item reports the net value of the company—how much your company is worth if you decide to liquidate all your assets.
Shareholders' Equity = Total Assets − Total Liabilities
Retained earnings are not the same as shareholders' equity. Retained are part of your total assets, though—so you'll include them alongside your other liabilities if you use the equation above.
Shareholders equity—also stockholders' equity—is important if you are selling your business, or planning to bring on new investors. In that case, they'll look at your stockholders' equity in order to measure your company's worth.
Also, keep in mind that the equation you use to get shareholders' equity is the same you use to get your working capital. Working capital is the value of all your assets, minus liabilities. It's a measure of the resources your small business has at its disposal to fund day-to-day operations.
Retained earnings provide a much clearer picture of your business' financial health than net income can. If a potential investor is looking at your books, they're most likely interested in your retained earnings.
Why? Things like revenue and expenses can fluctuate month-to-month. If an investor is looking at December's financial reporting, they're only seeing December's net income. But retained earnings provides a longer view of how your business has earned, saved, and invested since day one.
Not sure if you've been calculating your retained earnings correctly? Try a bookkeeping service like Accracy. We'll pair you with a bookkeeper to calculate your retained earnings for you so you'll always be able to see where you're at.
We are offering free 1 Month Basic Bookkeeping to all new customers so you can experience Accracy's seemless and professional services.
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