Retained earnings formula (and how to calculate them)
As in everyday life, savings are hugely significant, and the same goes for businesses in the form of retained earnings. Retained earnings can fund future growth projects of a company or dividends for shareholders. Therefore, understanding retained earnings is crucial for business managers planning for the future and financial forecasting. In this article, we look at what retained earnings are, the benefits and how to calculate them.
What is a retained earnings formula?
Retained earnings are the number of a business's profits that are not dispersed as dividends. In short, retained earnings is what they have left after paying shareholders. A retained earnings formula is used to calculate this. Therefore, the number of profits leftover is what the company retains. Sometimes, a business may choose to use these retained earnings to support growth. However, it's important to note that some view retained earnings as a conservative dividend policy, meaning shareholders do not get the full benefit of the company.
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Benefits of retained earnings
There are several critical benefits of retained earnings:
Cheaper source of financing: Using retained earnings to finance growth in the business does not involve any cost of acquisition.
Financial Stability: Retained earnings strengthen the financial position of the company and give financial stability to the firm.
Stable dividend: Even if the business does not earn enough profit, shareholders may still get stable dividends if retained earnings are present.
Market value: Retained earnings increase a business's financial stability and market value, appreciating the capital. As a knock-on effect, the market value of shares increases.
Disadvantages of retained earnings: While there are some significant advantages to RE, there are, of course, some downsides. The key disadvantages are:
Lack of control of funds: If the purpose for the expenditure of retained earnings is not stated clearly, the business may spend the money set aside unwisely or carelessly
Over-capitalisation: Conservative dividend policy can lead to the accumulation of large amounts of retained earnings, leading to overcapitalisation
Lower rate of dividend: Retained earnings mean that less money is being paid out to shareholders, not allowing them to enjoy the full benefit of the company. This can create unrest in shareholders and adversely affect the market value of shares.
Lack of meaningful insight: For individuals wishing to analyse the success of a company, retained earnings may not provide incisive insight. Viewing the build-up or lack of accumulation of retained earnings over time may only show how much money is being put aside, rather than growth or expansion due to money earned.
The purpose of retained earnings
Retained earnings serve a purpose in the same way that workers may save a portion of their salary each month. While an employee might put money aside for a holiday or a car, a business may set aside retained earnings for future expansion at a later date. This strategy could be helpful in a recession or to prepare for the likelihood of an economic downturn.
Retained earnings vs revenue
While revenue and RE are vital KPIs in evaluating a company's financial health, they paint different pictures of a business's financial health. Revenue is the first KPI that analysts may look for at the top of the income statement and can give a solid indicator of how a company is performing. Revenue is the money earned by a company during a set period, but before deducting costs and expenses.
Retained earnings vs dividends
When shareholders receive dividends, this can happen in the form of either cash or stock payments. Both forms of payment reduce retained earnings. Accountants record cash payments of dividends as net reductions and lead to cash outflow. RE is a lower amount because the company's asset value is smaller on the balance sheet.
With stock dividends, the stock payment converts part of the RE to common stock. For example, if a business pays one share as a dividend for each share held by investors, the price per share may reduce because the number of shares could increase. Although the increase in shares may not affect the balance sheet, it decreases the per-share valuation. Capital accounts reflect this, consequently affecting the retained earnings.
The retained earnings formula
The formula for calculating retained earnings is:
Retained earnings = beginning retained earnings + net income or loss – dividends
Example: A business may begin an accounting period with £10,000 of retained earnings. These are the retained earnings that have carried over from the previous accounting period. The business then brings in £6,000 in net income and pays £3,000 in dividends. The calculation for this would £10,000 + £6,000 - £3,000 = £13,000. The company has RE of £13,000 for this accounting period.
The RE of a business accumulates over its lifespan and may roll over into each new accounting period or tax year. If a company is successful and therefore profitable, it may have RE that increases each period. Of course, this depends on how the business spends its retained earnings or whether it saves the retained earnings for future use.
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Interpreting the results of the retained earnings formula
If a business has positive retained earnings, then the company is profitable. This is because a business's retained earnings show profits after the payment of dividends and overheads. If the business has negative RE, it has built up more debt than the earnings it has generated. It's crucial to remember the overall picture of a company's situation before evaluating retained earnings. If a business has been trading for several years, negative RE could show that the company is not profitable, and a review is needed. When looking at the retained earnings of a business, the following factors can come into play:
The age of the company: A smaller company may not have had much time to accumulate retained earnings, so it would therefore have a smaller RE amount. Conversely, a senior company may have had more time, so it has a higher RE amount.
A company's dividend policy: If a company regularly gives out dividends, it may have a lower amount of retained earnings. A conservative dividend policy would mean a higher amount of RE, which would be typical for privately held companies.
A company's profitability: The more profitable a business is, the higher its amount of retained earnings may be.
The seasonality of a company: In seasonal industries such as the hospitality industry, businesses may need to hold back retained earnings during profitable periods to help them through quieter spells of the year. Accounting periods would reflect this with high RE and other periods of lower or negative retained earnings.
Managing retained earnings
With capital building up in the form of retained earnings, deciding what to do with the accumulation is a significant decision and not one to be taken lightly. The decision typically is made by the management of the company. However, business shareholders can dispute this through a majority vote, as they're the company's principal owners. Both management and shareholders may want the RE to be held back for several different reasons. The management and shareholders may be well informed about the market and the future of the business, meaning they could have a growth plan in place that the RE might fund.
The growth plan would then generate more income for the business, which is beneficial for the shareholders as it would mean they would receive higher or more frequent dividend payments in the future. But with extra income, the shareholders may feel that the business owes them some regular income as a reward for funding the business in the first place.
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Examples of retained earnings
Below are examples of retained earnings:
Bee Logistics begins a new accounting period with £100,000 in retained earnings. Over the accounting period, the company brings in £25,000 in net income. At the end of the accounting period, the company's board decides to pay out £5,000 in dividends to its shareholders.
Therefore, the formula for the company's retained earnings at the end of the accounting period would be £100,000 + £25,000 - £5,000 = £120,000. This means that the company's total retained earnings are £120,000 for the accounting period. This amount is carried over to the new accounting period and can be used to reinvest into the company or to pay future dividends.
Now let's say that Bee Logistics begins a new accounting period with £100,000 in retained earnings. Over the accounting period, the company posts a net loss of £25,000. At the end of the accounting period, the company's board pays out £5,000 in dividends to its shareholders.
The formula for the company's retained earnings would be: £100,000 - £25,000 - £5,000 = £70,000. This amount is carried over to the new accounting period and can be used to reinvest into the company or to pay future dividends.
Disclaimer: The model shown is for illustration purposes only, and may require additional formatting to meet accepted standards.
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