Retained earnings are one of the most important areas on the balance sheet that draw focus from owners, investors and stakeholders. It can be a quick way to get an understanding if a company has been accumulating profits over the years. We’ll look to understand what are retained earnings, why they show up on the balance sheet and how they are different from revenue.
What Are Retained Earnings? ( A Definition)
Retained earnings is the amount on the balance sheet that is retained from net income at the end of each accounting period. The key is that this amount is retained. A business can hold onto this net income and use it over future accounting periods.
Where Do You Find Retained Earnings?
As retained earnings accumulate and build up, you’ll find it in the shareholder’s equity section on the balance sheet. Remember the basic accounting equation: Assets = Liabilities + Owner’s Equity. Look to find retained earnings on the balance sheet in the equity section.
Often this is the last section on the balance sheet as assets are presented first, then liabilities and often equity is last.
How Do You Calculate Retained Earnings?
Calculating retained earnings may seem easier for smaller companies than large companies but the method is the same. You are going to follow these steps:
- Find your beginning retained earnings on the balance sheet.
- Add the net income or loss for the accounting period.
- Finally, subtract dividends that are paid to shareholders.
Let’s try a practical example. Imagine Sally’s Sweets is a large baking company with multiple locations. Her retained earnings ending 2022 is $63,000. She has a net income of $12,000 for the period and pays dividends of $1,000.
Take the previous ending retained earnings of $63,000 as the beginning balance. Add the net income of $12,000 and subtract the $1,000 of dividends paid.
Since this is an accumulating account on the balance sheet as we mentioned, the new account’s total of retained earnings would be $74,000 for the period ended.
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Why Are Retained Earnings Important?
At a high-level view of a company, retained earnings can show if a company is growing year over year or if they have had losing years. Take a company like Sally’s Sweets that retained earnings of $63,000 in the previous year and then $74,000 in the next year. It is clear that the company was generating profits.
The next thing retained earnings can show is the ability to pay out dividends or distribute profits to the shareholders. You may notice that some large blue-chip companies keep quite a bit of retained earnings to pay out dividends. It is common that new companies don’t pay out a dividend at all while they try to build up their retained earnings. That said, they might not have retained earnings at all.
Can You Have Negative Retained Earnings?
It might sound surprising but it isn’t far-fetched to have negative retained earnings. Think about a company that is generating year-over-year losses. This could be a start-up or even a mature company that pays out dividends which leads to negative retained earnings.
Checking the health of retained earnings is more important than most people give credit to. It should be one of the first places to look when reading over a company’s financials but at the same time, you can’t put all your value of analysis just in a retained earnings number.
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What is Shareholder Equity?
Taking a step back, we noted that retained earnings are found in the equity section of the balance sheet. More specifically, it is found in shareholder’s equity when the structure is a company.
Shareholder’s equity is not just retained earnings but also paid-in capital and other comprehensive income.
As retained earnings increase or decrease like in our example, it directly impacts shareholder’s equity and any increase or decrease in the account. It is important to be aware of the multiple components of shareholder’s equity and just know that it isn’t solely made up of retained earnings.
How are Retained Earnings Different From Revenue?
The terms may sound similar and you may think of money coming in but there are big differences between retained earnings and revenue. Not to be confused. Revenue is the top-of-the-line income statement figure that is reported from sales.
Retained earnings is all the way after you have subtracted expenses from revenue, found net income and determined how much of your earnings the company will retain. Retained earnings is a balance sheet figure unlike revenue which is an income statement figure.
Which is More Important: Revenue or Retained Earnings?
While revenue is a great figure to see that the company is making sales and earning money, retained earnings tell a bit more about the health of a business. Is the company consistently racking up losses from year to year? Have they been building up a war chest of funds? Retained earnings can answer all of these questions at a high level and more.
How are Retained Earnings Different From Net Income?
Net income is another figure shown on the income statement but instead a bottom line figure when compared to revenue. The thing that separates net income from retained earnings is not only one being on the income statement and the other being on the balance sheet but dividends.
Dividends are paid out to shareholders after net income is arrived at and only then do you get to retained earnings on the balance sheet.
Recapping Retained Earnings on the Balance Sheet
So we have talked all about retained earnings but let’s summarize what we have learned.
- Retained earnings show up on the balance sheet as part of equity.
- You arrive at retained earnings after subtracting dividends from net income.
- Retained earnings are the earnings retained for a period of business, hence accumulated profits.
- Retained earnings are different from revenue and net income.
What are Retained Earnings on the Balance Sheet? Final Thoughts
While retained earnings can’t tell you everything about the business by looking at them alone on a balance sheet, they can be used with other items on a balance sheet and income statement to paint a full financial picture for a company. It is always worth looking at retained earnings when you initially review the financials of a company and get a starting point.
