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Retained Earnings are the profits a business has accumulated that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business. These funds can be used for a variety of purposes, including working capital, purchasing fixed assets, and paying off debt. Retained earnings are an important part of any business because they provide the means to reinvest in and grow your business. Companies with a healthy retained earnings balance will often try to achieve a balance between rewarding owners/shareholders while also financing business growth.Read on to learn why retained earnings are important for every business, how to calculate retained earnings, and how these funds can be used.
What Are Retained Earnings?
By definition, retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. In other words, retained earnings are the profit that a business generates after costs such as salaries or production have been accounted for, and once any dividends have been paid out to owners or shareholders. Retained earnings are reported on a company's balance sheet under owners’/shareholder’s equity, which is a measure of what a business is worth. Retained earnings value can fluctuate from quarter to quarter and year to year depending on whether they are accumulating or being used. If you run a very small business, you might not even account for retained earnings and simply consider them part of working capital. However, it can be worth recording retained earnings in accounting. For one reason, lenders may want to see your company’s retained earnings if you apply for a small business loan.
How Do You Use Retained Earnings?
Retained earnings can be used for a variety of purposes. Here’s a look at some of the options.
Used to Pay Back Business Loans
Many businesses are financed with various types of small business loans. Ultimately, those obligations must be paid back, and retained earnings are often used to do that. Repaying debt early can also save on interest costs, boosting profits and future retained earnings. (Keep in mind, however, that some lenders may charge a prepayment penalty.)
Mergers and Acquisitions
Retained earnings can also be used to grow a business by funding a merger, business acquisition, or partnership that could open up the company up to new opportunities.
Share Buybacks
If a company’s owner or management does not believe it can earn a sufficient return on investment from its retained earnings, it might conduct share buybacks. This involves paying shareholders the market value per share and re-absorbing that portion of the company’s ownership.
Other Types of Reinvestment
Retained earnings may be reinvested into the company in order to:
Launch a new product/variant
Increase production capacity of the existing products
Hire more staff
Buy new equipment and machines
Invest in research and development
This reinvestment into the company aims to achieve even more earnings in the future.
Pros and Cons of Retained Earnings
Retained earnings have both advantages and disadvantages. Here’s a look at how they stack up.
Pros of Retained Earnings
They are an inexpensive source of funds, since (unlike loans), there are no interest payments or fees.
There are no conditions on how you can spend the money.
They can increase your future retained earnings if re-invested wisely.
They can be used to repay high-interest loans, as well as short-term debt to reduce accounts payable.
Cons of Retained Earnings
The amount of retained earnings rises and falls depending on profit trends and dividend payouts.
If shareholders believe you are not using the money effectively, they may feel cheated out of dividend income.
Owners and managers may decide to spend the funds simply because the money is there and potentially waste it.
High retained earnings could cause owners/managers to make risky investments.
Retained Earnings Formula Explained
In small business accounting, the retained earnings formula starts with the beginning-of-period retained earnings amount. That is carried over from the prior period’s retained earnings figure. Net income (or net loss), located at the bottom of the income statement, is then added to the first figure. Dividends, both the cash and stock types, must be removed to arrive at the end-of-period retained earnings amount. Here is the retained earnings formula:RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock DividendsWhere RE = Retained Earnings
Calculating Retained Earnings
At the end of each accounting period, retained earnings are reported on the balance sheet. In the next accounting cycle, the retained earnings ending balance from the previous accounting period will now become the retained earnings beginning balance.It’s possible for this balance to be negative. This could happen if the current period’s net loss is greater than the retained earnings beginning balance, or if a distribution of dividends exceeds the retained earnings balance.Any factors that impact net income (such as changes in sales revenue, cost of goods sold, depreciation, and other operating expenses) will directly affect the retained earnings balance. Recommended: How to Calculate Cash Flow (Formula & Examples)
Are Retained Earnings a Debit or Credit?
The normal balance in the retained earnings account is a credit. This balance indicates that the business has generated an overall profit over its life. However, the amount of the retained earnings balance could be relatively low even for a financially healthy company, since dividends are paid out from this account. Consequently, the amount of the credit balance does not necessarily indicate the relative success of a business.When the balance in the retained earnings account is negative, this indicates that a business has generated an overall loss over its life. This often happens during the startup years of a business, when it may incur sustained losses before it has accumulated enough customers and released enough products to bring in a reasonable profit.
Retained Earnings vs Dividends vs Revenue
Retained earnings, dividends, and revenue are all important ways to measure a company's financial health. Each, however, looks at a different component of a company’s finances.Dividends, whether distributed in the form of cash or stock, reduce retained earnings. If a company is focused on growth, it might not pay dividends or pay very small dividends and instead use the retained earnings to invest in new equipment, research and development, marketing, and/or acquisitions to boost growth. If this is the case, the company will have high retained earnings.A more mature company, on the other hand, may not have many options for investing surplus cash and might prefer to pay dividends. In this case, a company will have low retained earnings. Revenue refers to the total earnings a company generates through its core operations before removing any expenses.
The Takeaway
Retained earnings are the amount of net income left over for a company after it has paid out dividends to its shareholders. The business owner or management can decide whether to keep the earnings or distribute them among the shareholders. When a company is focused on growth, it may choose to use all or most of the retained earnings to fund expansion activities. Businesses in later stages might opt to use the money to pay additional dividends.Retained earnings can also be used to determine whether a business is truly profitable. Lenders, creditor’s, and investors will often look at a company's retained earnings, along with its revenue, to gain insights into the firm’s financial performance and potential for growth.
3 Small Business Loan Tips
Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
Traditionally, lenders like to see a business that’s at least two years old when considering a small business loan.
SBA loans are guaranteed by the U.S. Small Business Administration and typically offer favorable terms. They can also have more complicated applications and requirements than non-SBA business loans.
Frequently Asked Questions
What are some examples of retained earnings?
How are retained earnings calculated?
Are retained earnings assets or liabilities?
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About the Author
Mike Zaccardi
Mike Zaccardi, CFA, CMT, is a finance expert and writer specializing in investments, markets, personal finance, and retirement planning. He enjoys putting a narrative to complex financial data and concepts; analyzing stock market sectors, ETFs, economic data, and broad market conditions; and producing snackable content for various audiences.
