Retained earnings represent a useful link between a company’s income statement and balance sheet As an accumulated equity account that reflects net income not paid out as dividends, retained earnings connect the profit and loss statement with the statement of financial position This article provides an in-depth look at retained earnings on the balance sheet – from calculating the balance to analyzing trends over time.
What are Retained Earnings?
Retained earnings (RE) refer to the portion of net income that a company retains or keeps, as opposed to distributing it among shareholders in the form of dividends. The RE account appears in the shareholders’ equity section of the balance sheet and increases with profitability or net income. Conversely, retained earnings decrease when a business incurs a net loss or pays dividends.
Retained earnings belong to shareholders and represent the accumulated profits since a company’s inception. Companies reinvest retained earnings for purchases such as new equipment or expansion rather than pay dividends. High-growth companies tend to retain more earnings for reinvestment into the business. More mature, slower-growth companies are more likely to pay dividends.
The Retained Earnings Formula
The retained earnings formula starts with the beginning RE balance, adds net income and subtracts dividends
Retained Earnings = Beginning RE + Net Income – Dividends
Where:
- Beginning retained earnings: Prior year’s ending RE balance
- Net income: The “bottom line” on the income statement
- Dividends: Cash or stock dividends paid to shareholders
This formula updates retained earnings each accounting period. The new RE balance then becomes the beginning balance for the next period.
Finding Retained Earnings on the Balance Sheet
Public companies include retained earnings on their balance sheet. It appears as a line item under the shareholders’ equity section, also known as net assets. Retained earnings sit alongside other key accounts like common stock and treasury stock.
On the balance sheet, retained earnings represent a running total of profits left over after dividend payments to shareholders. Companies may have negative retained earnings if cumulative net losses exceed profits.
Here is an example retained earnings section from the balance sheet:
Shareholders’ Equity
Common stock: $10,000
Retained Earnings: $15,000
Treasury Stock: ($2,000)
Total Shareholders’ Equity: $23,000
Retained earnings of $15,000 represent the cumulative net income not paid out to shareholders. This figure transfers from the retained earnings statement.
Analyzing Trends in Retained Earnings
Reviewing a series of historical retained earnings balances offers insight into a company’s profitability and dividend trends over time. Retained earnings should increase steadily if a company consistently earns profits. However, analyzing retained earnings involves more than just tracking growth.
Specifically, consider the following factors when analyzing retained earnings trends:
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Growth rates: Rapid growth may indicate the company is investing retained earnings wisely. Slower growth could signal high dividend payments.
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Losses: Occasional losses are expected, but consistent losses can quickly deplete retained earnings.
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Dividend payments: High regular dividends lower retained earnings growth compared to non-dividend payers.
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Share buybacks: Share repurchases also reduce retained earnings rather than paying dividends.
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Acquisitions: Large acquisitions slow retained earnings growth as companies divert profits.
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Industry: Compare growth rates to industry competitors. Significantly lower growth than peers warrants a closer look.
Evaluating retained earnings trends over a multi-year period provides insight into a company’s profitability, growth, and capital allocation strategies. Year-over-year variances also reflect the impact of gains, losses, and evolving dividend policies on accumulated earnings.
Retained Earnings vs. Revenue
While related, retained earnings and revenue figures measure different aspects of financial performance. Revenue solely reflects the income earned during an accounting period. Retained earnings represent the cumulative profits kept over a company’s operating history.
For example, a company earns $100 million in net income in Year 1. Its retained earnings balance at the end of the year is $100 million. In Year 2, it earns $150 million in net income. At the end of Year 2, retained earnings equal $250 million. The Year 2 revenue is $150 million, while cumulative retained earnings stand at $250 million after two years of operations.
Negative Retained Earnings
It is possible for retained earnings to have a negative balance if a company’s accumulated net losses exceed its net income. This occurs when a business continues losing money over multiple accounting periods. The retained earnings account decreases and can fall below zero if cumulative losses remain on the balance sheet.
Several factors can cause sustained unprofitability, including economic recessions, competition, poor management, or disruptive technologies. Companies with negative retained earnings must either earn profits or liquidate assets to cover their deficit. If the company cannot reverse the losses, it risks insolvency and bankruptcy.
Retained Earnings vs. Treasury Stock
Both retained earnings and treasury stock appear under shareholders’ equity but represent very different items:
- Retained earnings: Cumulative income not paid as dividends
- Treasury stock: Repurchased outstanding shares
Companies buy back shares and hold them without retiring them as treasury stock. These repurchased but still authorized shares allow companies to reissue them in the future. Treasury stock appears as a negative balance reducing equity.
In contrast, retained earnings represent cumulative profit rather than paid-in capital from stock issuances. While treasury stock provides a bookkeeping entry for buybacks, retained earnings reflect income earned.
Key Takeaways
- Retained earnings represent the accumulated net income businesses do not pay out as shareholder dividends.
- The retained earnings account on the balance sheet reflects profits a company keeps to reinvest or distribute later.
- Analyzing retained earnings over time provides insight into profitability, dividend policy, and growth trends.
- It is possible for retained earnings to have a negative balance if cumulative losses exceed profits.
- Retained earnings and treasury stock both reduce shareholders’ equity but represent very different activities.
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 for 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.
The Purpose of Retained Earnings
Retained earnings represent a useful link between the income statement and the balance sheet, as they are recorded under shareholders’ equity, which connects the two statements. The purpose of retaining these earnings can be varied and 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 return on investment from those retained earnings (i.e., earn more than their cost of capital), then they will often distribute those earnings to shareholders as dividends or conduct a share buybacks.
Retained Earnings explained
What is retained earnings formula?
The retained earnings formula calculates the balance in the retained earnings account at the end of an accounting period. As stated above, it is the profit after tax that remains after the dividends have been distributed to the shareholders. Accordingly, the retained earnings formula is as follows:
What is a statement of retained earnings?
A summary report called a statement of retained earnings is also maintained, outlining the changes in RE for a specific period. Retained earnings represent a useful link between the income statement and the balance sheet, as they are recorded under shareholders’ equity, which connects the two statements.
What is a Retained Earnings balance?
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.
Where can I find a company’s Retained Earnings balance?
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. To fully understand a company’s retained earnings, let’s break down the crucial factors to consider:
