The accumulation of net income after dividends
The accumulation of net income after dividends
Retained Earnings (RE) are the portion of the business’s profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business. Naturally, these funds are used for working capital and fixed asset purchases or allotted for debt obligations.
Retained Earnings are reported on the balance sheet under the shareholder’s equity section at the end of each accounting period. To calculate RE, the beginning retained earning balance is added to the net income or loss and then dividend payouts are subtracted. A summary report called a statement of retained earnings is also maintained, outlining the changes in RE for a specific period.
Retained earnings represent is a useful link between the income statement and the balance sheet, as they are recorded under shareholders’ equity on the balance sheet. The purpose of retaining these earnings can be varied, which includes buying new equipment and machines, spending on research and development or other activities that could potentially generate growth for the company. This reinvestment into the company aims to achieve even more earnings in the future. If a company does not believe it can earn a sufficient rate of return on those retained earnings (i.e. earn their cost of capital) then they will often distribute those earnings to shareholders as dividends or share buybacks.
The RE formula is as follows:
RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends
Where RE = Retained Earnings
At the end of each accounting period, retained earnings are reported on the balance sheet as the accumulated income from the prior year (including the current year’s income) minus dividends paid to shareholders. In the next accounting cycle, the RE ending balance from the previous accounting period will now become the retained earnings beginning balance. The RE balance may not always be a positive number as it may reflect that the current period’s net loss is greater than that of the retained earnings beginning balance. Alternatively, a large distribution of dividends that exceed the retained earnings balance can cause it to go negative.
Any changes or movement with net income will directly impact the RE balance. Factors, such as an increase or decrease in net income and incurrence of net loss, will pave the way to either business profitability or deficit. The Retained Earnings account can be negative due to large, cumulative net losses. Naturally, items that affect net income affect RE. Examples of these items include sales revenue, cost of goods sold, depreciation and other operating expenses. Non-cash items such as write-downs or impairments also affect the account.
Distribution of dividends to shareholders can be in the form of cash or stock. Both forms can reduce the value of RE by the business. Cash dividends represent a cash outflow and are recorded as reductions in the cash account. These reduce the size of a company’s balance sheet and asset value as the company no longer owns part of its liquid assets. Stock dividends, however, do not require a cash outflow. Instead, they reallocate a portion of the RE to common stock and additional paid-in capital accounts. This allocation does not impact the overall size of the company’s balance sheet, but it does decrease the value of stocks per share.
Learn more: how to forecast a company’s balance sheet.
At the end of the period, you can calculate your final Retained Earnings balance for the balance sheet by taking the beginning period, adding any net income or net loss, and subtracting any dividends.
In this example, the amount of dividends paid by XYZ is unknown to us, so using the information from the Balance Sheet and the Income Statement, we can derive it remembering the formula Beginning RE – Ending RE + Net income (-loss) = Dividends paid
We already know:
Beginning RE: $77,232
Ending RE: $78,732
Net Income: $5,297
So, $77,232 – $78,732 + $5,297= $3,797
Dividends paid = $3,797
We can confirm this is correct by applying the formula of Beginning RE + Net income (loss) – dividends = Ending RE
We have then $77,232 + $5,297 – $3,797 = $78,732, which is in fact our figure for Ending Retained Earnings
In financial modeling, it’s necessary to have a separate schedule for modeling retained earnings. The schedule uses a corkscrew type calculation, where the current period opening balance is equal to the prior period closing balance. In between the opening and closing balances, the current period net income/loss is added and any dividends are deducted. Finally, the closing balance of the schedule links to the balance sheet. This helps complete the process of linking the 3 financial statements in Excel.
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This guide to Retained Earnings has outlined the most importing things you need to know: what is, how to you calculate it, and it’s important. From here we recommend continuing to build out your knowledge and understanding of more corporate finance topics such as: