Retained Earnings

The accumulation of net income after dividends

What are Retained Earnings?

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 retained earnings, 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 retained earnings for a specific period.

 

retained earnings

 

What is the retained earnings formula?

The Retained Earnings formula is as follows:

Retained Earnings = Beginning Period Retained Earnings + Net Income/Loss – Cash Dividends – Stock Dividends

 

For example:

Republic Company has a beginning retained earning balance of $1.5M and at the end of the year declared a net profit of $400,000. During the year, the company distributed cash dividends to its shareholders amounting to $150,000. As a result, the RE ending balance is now valued at $1.75M.

 

Beginning of period 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 retained earnings 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.

 

How Net Income impacts Retained Earnings

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.

 

retained earnings in a model

 

How Dividends impact Retained Earnings

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.

 

End of period Retained Earnings

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 and dividends.

 

Applications in financial modeling

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.

To learn more, check out our video-based financial modeling courses.

 

More learnings and resources

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: