Retained Earnings
Learn how to find and calculate retained earnings using a company’s financial statements.
Key Takeaways
- Retained earnings capture the cumulative profits or net earnings a company has produced over a period of time after accounting for any dividends paid to shareholders.
- Expansion, investment, debt reduction, and stock repurchasing are four common uses of a company’s retained earnings balance.
- Retained earnings is a standardized accounting item that offers a comprehensive evaluation of a company's financial stability and long-term growth potential.
Retained Earnings Explained
Retained earnings are an important component of a company's financial health, representing the cumulative profits or net earnings that a company has generated over time after accounting for any dividend payments made to shareholders. These earnings are considered "retained" because they have not been distributed to shareholders as dividends but have instead been kept by the company for future use.
For investors and financial analysts, retained earnings are essential since they offer in-depth insights into a company's long-term growth potential. A company with a high level of retained earnings indicates that it has been able to generate consistent profits, which can be used for reinvestment in the business or to fund future growth opportunities.
Retained Earnings Formula
The retained earnings formula provides a way to calculate a company's retained earnings at the end of a specific period:
Ending Retained Earnings (RE) = Beginning Period Retained Earnings (BP) + Net Income (or Loss) - Cash Dividends (C) - Stock Dividends (S)
By subtracting the cash and stock dividends from the net income, the formula calculates the profits a company has retained at the end of the period. If the result is positive, it means the company has added to its retained earnings balance, while a negative result indicates a reduction in retained earnings.
Now, let's uncover the components that make up the retained earnings calculation.
- Beginning Period Retained Earnings: Accumulated earnings from prior years, influenced by profits, losses, or dividends paid out.
- Net income: The total earnings in the current fiscal year, calculated by subtracting expenses from revenue.
- Dividends: The company's way of rewarding shareholders for their investment, either as cash or stock bonuses.
Where to Find Retained Earnings in the Financial Statements
You’ll want to find the financial statements section of a company’s annual report in order to find a company’s retained earnings balance and all the supporting figures you’ll need to complete the calculation.
- Retained Earnings can be found in the shareholders’ equity section of a company’s balance sheet.
- Net Income can be found near the end of a company’s income statement after all expenses have been deducted from revenue.
- Dividends can be found in the financing activities section of a company’s statement of cash flows.
Understanding Retained Earnings
Retained earnings offer valuable insights into a company's financial health and future prospects. When a business earns a surplus income, it can either distribute the surplus as dividends to shareholders or reinvest the balance as retained earnings.
In all instances, investors seek maximum returns on their investments and prefer that companies retain surplus profits for higher returns if they have faith in the management's capabilities and know that the company has profitable investment opportunities. If a company has no strong growth opportunities, investors would likely prefer to receive a dividend. Therefore, the company must balance declaring dividends and retained earnings for expansion.
Four common uses of retained earnings are:
- Expansion: Companies often use retained earnings to finance expansion efforts, such as opening new locations or expanding existing ones. Setting a budget and maintaining a balance between growth and profitability is important.
- Investment: Investing in other businesses or assets is another use of retained earnings. This can be risky but can also lead to profitable returns for further business growth.
- Debt Reduction: Many businesses use retained earnings to pay down debt, which can improve financial health and reduce interest expenses. Prioritizing which debts to pay off is essential.
- Share Repurchases: Some companies use retained earnings to repurchase shares of stock from shareholders. This can increase existing shareholders' ownership stakes or reduce the number of outstanding shares.
The Importance of Retained Earnings
Retained earnings can be used to assess a company's financial strength. When lenders and investors evaluate a business, they often look beyond monthly net profit figures and focus on retained earnings. This is because retained earnings provide a more comprehensive overview of the company's financial stability and long-term growth potential.
Unlike net income, which can be influenced by various factors and may fluctuate significantly between periods, retained earnings offer a more consistent and reliable indicator of the business's financial health. A strong retained earnings figure suggests that a company is generating profits and reinvesting them back into the business, which can lead to increased growth and profitability in the future.
The level of retained earnings can guide businesses in making important investment decisions. If retained earnings are low, it may be wiser to hold onto the funds and use them as a financial cushion in case of unforeseen expenses or cash flow issues rather than distributing them as dividends. However, if both the net profit and retained earnings are substantial, it may be time to consider investing in expanding the business with new equipment, facilities, or other growth opportunities.
A company’s retained earnings balance can be found on the shareholder’s equity section of the balance sheet (one of the 3 core financial statements), which can be found in the company's annual report or website.
Factors Influencing Retained Earnings
To fully understand a company's retained earnings, let's break down the crucial factors to consider:
- Company Age: Companies with a long history will have more time to build up a higher retained earnings balance.
- Dividend Policy: Enterprises that regularly distribute dividends may have lower retained earnings as they consistently pay out a portion of their earnings to shareholders.
- Profitability: Highly profitable companies will typically have higher retained earnings, as they have more money left over after paying expenses.
- Seasonality: In industries with seasonal fluctuations, such as retail, companies may need to hold onto their earnings during profitable periods to compensate for slower periods. This can result in accounting periods with high retained earnings and periods with lower or negative retained earnings.
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Example Retained Earnings Calculations
Scenario 1 - Bright Ideas Co. starts a new accounting period with $200,000 in retained earnings. During the accounting period, the company earns $50,000 in net income. After the accounting period ends, the company's board of directors decides to pay out $20,000 in dividends to shareholders.
Retained Earnings Calculation:
- Beginning Period Retained Earnings = $200,000
- Net Income = $50,000
- Dividends = $20,000
- Ending Retained Earnings = $230,000
The formula for the company's retained earnings at the end of the accounting period would be: $200,000 + $50,000 - $20,000 = $230,000. This amount will be carried over to the new accounting period and can be used to reinvest in the company or to pay future dividends.
Scenario 2 - Let's assume that Bright Ideas Co. begins a new accounting period with $250,000 in retained earnings. During the accounting period, the company records a net loss of $20,000. When the accounting period is finalized, the directors’ board opts to pay out $15,000 in dividends to its shareholders.
Retained Earnings Calculation:
- Beginning Period Retained Earnings = $250,000
- Net Income = -$20,000
- Dividends = $15,000
- Ending Retained Earnings = $215,000
The final formula for the company's retained earnings would be: $250,000 - $20,000 - $15,000 = In this scenario, the company encounters negative net income while also distributing dividends which result in a subtraction of both from the beginning retained earnings balance.
Real Company Example: Coca-Cola Retained Earnings Calculation
Let’s walk through an example of calculating Coca-Cola’s real 2022 retained earnings balance by using the figures in their actual financial statements. You can find these figures on Coca-Cola’s 10-K annual report listed on the sec.gov website.
The company’s retained earnings calculation is laid out nicely in its consolidated statements of shareowners’ equity statement. Here we can see the beginning balance of its retained earnings (shown as reinvested earnings), the net income for the period, and the dividends distributed to shareholders in the period.
Calculation Steps:
- Carry the ending retained earnings balance of 2021 (69,094) to the beginning balance of 2022.
- Add the net income generated in the 2022 fiscal year (9,542). You can check this figure by referencing the net income line on the company’s income statement.
- Deduct any dividends distributed to shareholders in 2022 (7,617).
- Ending retained earnings = $69,094 + $9,542 - $7,617 = $71,019.
Overall, Coca-Cola’s positive growth in retained earnings despite a sizeable distribution in dividends suggests that the company has a healthy income-generating business model. The growing retained earnings balance over the past few years could suggest that the company is preparing to use those funds to invest in new business projects.
Checking Financial Statement Figures
We can cross-check each of the formula figures used in the retained earnings calculation with the other financial statements.
We can find the retained earnings (shown as reinvested earnings) on the equity section of the company’s balance sheet.
We can find the net income for the period at the end of the company’s income statement (consolidated statements of income).
We can find the dividends paid to shareholders in the financing section of the company’s statement of cash flows.
Additional Resources
If you’re looking to further develop your technical accounting knowledge, consider checking out our Complete Finance & Valuation Course to join our students who have landed roles with Goldman Sachs, Bloomberg, EY, and other great companies!
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