What are retained earnings?
What are retained earnings?
What are retained earnings?
Retained earnings are important because they can fuel business stability and growth. Without retained earnings, the business may not have the funds or working capital it needs to invest in the future. When this is the case, the business may have to turn to loans or other funding sources, which can come with interest expenses and other fees. Also, retained earnings are a big piece of a business's equity; banks consider equity when deciding how much credit to extend to businesses.
Here are just a few ways businesses might use retained earnings:
- Purchasing new equipment: Retained earnings can be used to buy machines to drive efficiencies, increase production to meet market demands or add new products.
- Research and development: Before businesses can add new products, they need to develop them, and that costs money. Retained earnings can be used to support R&D efforts.
- Hiring: These funds can also be used to bring on new staff required to increase production, develop and market new products or otherwise support the business. While retained earnings can initially be used to hire and pay staff, the business must plan to increase overall profits to cover the ongoing expenses associated with labor in the future.
- Expanding to a new location: For brick-and-mortar locations, retained earnings may offer an opportunity to purchase or lease a new location to expand operations or break into a new market.
What’s an example of retained earnings?
Let's consider a hypothetical situation to better understand what retained earnings are and how they work. Imagine a toy manufacturing company experiences $5 million in sales. To get to retained earnings, we would need to subtract a number of elements.
In this example, expenses and other factors include:
- Variable and direct costs, such as wages and salaries, raw materials and inventory and overhead like utilities: $2 million.
- Fixed and indirect costs, such as a mortgage or rent, marketing expenses and insurance: $1.5 million
- Taxes: $200,000
The net profit for the business is $1.3 million. Now imagine that distributions of dividends equal $800,000. That leaves $500,000 in retained earnings the business can reinvest.
Retained earnings formula
The formula for retained earnings is:
Retained earnings = Beginning period retained earnings + Net income and losses - Cash dividends - Stock dividends
Let's break that down a bit for better understanding:
- Beginning period retained earnings: To calculate retained earnings, you must first set a period for the calculation. You might consider retained earnings for the month, quarter or year, for example. At the beginning of the period, you note any retained earnings that you start with. You'll need to add this starting amount to your retained earnings over the period in question so you know your total retained earnings.
- Net income and losses: You get this information from the balance sheet for the period. Income increases the amount you are calculating and losses decrease it.
- Cash dividends and stock dividends: The final step in the formula is to subtract all dividends the business paid out during the period in question.
How to calculate retained earnings
Let's use the toy manufacturer example above to see how the formula works.
Beginning period retained earnings
Imagine the toy manufacturer starts with $300,000 in retained earnings
$3,700,000 (variable and fixed costs as well as taxes)
Now let's plug those numbers into the formula:
- Retained earnings = Beginning period retained earnings + Net income and losses - Cash dividends - Stock dividends
- Retained earnings = $300,000 + $5,000,000 - $3,500,000 - $300,000 - $500,000
- Retained Earnings = $800,000
What can retained earnings tell you?
If you're the owner or leader of a business, retained earnings can help you understand the stability and financial health of your business. It's not the only number you should look at, obviously, but it does help indicate how solvent a business is, whether it has the resources it needs to grow or support itself in the future and how likely it is to get approved for credit.
If you're an investor, retained earnings can help you understand whether a business is worth investing in. If you see that a business has a strong history of retained earnings, you can surmise that it:
- Has adequate sales to support itself now and in the future
- Has cash reserves on a regular basis that can be turned to in times of economic upheaval, such as a major recession
- Has funds it can leverage to invest in equipment and other expenses necessary for growth
- Has equity it can use to seek funding for larger expenses, protecting its cash reserves and cash flow
Again, retained earnings is not the only factor you should look at when deciding whether to invest in or purchase a company. It’s one factor in the overall financial picture of the business's past and current success, and it enables investors to make educated forecasts about the possibility of future success.
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How dividends impact retained earnings
In the retained earnings formula, dividends reduce the amount left for retained earnings. The more dividends a business pays out, the less retained earnings it has.
Businesses distribute dividends in two ways: via cash and via stock. Cash dividends are money paid to shareholders. This is a cash outflow, so in the financial books, it's recorded as a reduction to the cash account for the business. In contrast, stock dividends are paid out via paid-in capital accounts and common stock.
Both of these dividend types reduce retained earnings, but only cash dividends reduce the balance sheet and value of the overall assets.
What is the difference between retained earnings and revenue?
Revenue refers to the amount a business earns from sales — whether those sales relate to services or goods. In the example above featuring the toy manufacturing company, the revenue is $5 million.
Revenue does not equal profit. To get to profit, you must subtract expenses and other losses from revenue. In the case of the toy manufacturer example, the profit would be $5 million minus the $3.7 million in costs and taxes. The profit would be $1.3 million.
Profit does not equal retained earnings, though. Profits are divided between shareholders (dividends) and the business (retained earnings).
Even though revenue and retained earnings aren't the same thing, revenue has a direct impact on retained earnings. When revenues go up — and costs go up in direct proportion — retained earnings also increase. When revenues go down, retained earnings also usually go down.
As an investor, it's important to look at both revenue and retained earnings. They both play a role in the financial health of a business. For example, you might see that a business has decent retained earnings. But if you look at revenue and see that it has been stagnant for five years, that might indicate that the business is not able to grow and might not be a great investment.
What does negative retained earnings mean?
Negative retained earnings occur when the company experiences a net income loss. In short, once you add and subtract all the numbers in the retained earnings formula, if you end up with a negative number, you have negative retained earnings.
Let's change the figures in our toy manufacturer example to see how a negative retained earnings situation might occur:
Beginning period retained earnings
$4,000,000 (variable and fixed costs as well as taxes)
In this scenario, the business didn't carry over any retained earnings from the previous period. It also experienced more losses — perhaps there was a disaster that led to increased costs or sudden increases in supply chain pricing drove up the cost of making goods. When you calculate retained earnings with these numbers, you end up with:
Retained earnings = $5,000,000 - 4,000,000 - 300,000 - 800,000
Retained earnings = -$100,000
Negative retained earnings can be a sign of money issues for a business. For business owners and leaders, this is a concern. First, they know they don't have cash to invest into their business, so growth may be more difficult. They also don't have a safety net of retained earnings that might help weather any future financial storms.
Investors may have the same concerns. Negative retained earnings can be a sign that a business may not be a good investment opportunity.
What is a good retained earning?
When considering what a good retained earning is, you must work in ratios. This is because $300,000 in retained earnings — or any other amount — might be a good figure for one company and a bad figure for another. This is because businesses all have different revenues, expenses and assets.
Instead of looking at the actual dollar figure of the retained earnings, you should look at the ratio of retained earnings to other assets. A 1:1, or 100%, ratio is best.
For example, say a business has assets totaling $500,000. Of those assets, $250,000 are retained earnings. The ratio of retained earnings to other assets is $250,000:$250,000, or 1:1. This is ideal.
What if the business had $500,000 in assets and only $100,000 were retained earnings? That's a ratio of 1:4. Or if you're using percentages, 20% of the assets are retained earnings. This would not be ideal.
It's not actually realistic to always have a 1:1 ratio, though, and in some industries, it may not be possible. Instead, businesses should understand what the average ratio for their industry is. They should strive for a ratio that is at or above that average.
The bottom line
Retained earnings are an important part of a business's financial picture. Investors should consider this, along with many other factors, when deciding whether or not to invest in a company.
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