One of the most important financial and accounting concepts to be aware of when it comes to your company is retained earnings. Retained earnings can be seen as a business savings account that can grow or decrease, based on financial decisions. Mathematically, retained earnings are determined by:
Retained earnings = Net income – dividends + beginning retained earnings balance.
Let’s assume this business scenario. A company currently has $10,000 in beginning retained earnings along with $7,000 in profit. During this set time the company paid $4,000 in dividends. Using the formula, the company’s current retained earnings value would be $13,000. ($7,000 – $4,000 + $10,000).
It’s important to note that retained earnings are not the same as net income, also known as revenue. Instead, retained earnings are based on a company’s total profit along with other factors. Retained earnings are a historical count of net earnings that haven’t been paid out to shareholders.
No matter the business type or industry retained earnings either end up being invested back into the company or handed out to shareholders as cash or cash equivalents. A company’s retained earnings can grow significantly or decrease, depending on assets, total profit, paid dividends, sales, debt interest, and many other financial factors.
Many companies choose to reinvest part or all of their retained earnings back into the company, such as buying new property or equipment, buying a competing company, or releasing a new product. In theory, reinvesting retained funds increases the business’ value and increases the chances of generating more profit in the future.
Where to Find Retained Earnings Information
Know that you know the ins and outs of retained earnings, how they’re calculated, and what they can be used for, it’s also beneficial to know where you can find this figure and why it’s so important for the direction of your small business.
A statement of retained earnings depicts the total amount of equity in a business during a specific time period. By tracking and analyzing past and current retained earnings statements, you can get a clear idea of whether or not your business is growing and how past financial decisions have impacted the company.
Why Retained Earnings Are Important
As a business owner you have all sorts of numbers to keep tabs on, so why are retained earnings worth tracking and reviewing on a consistent basis? Business owners and the board of directors care about retained earnings because it shows how much money is available to redistribute to shareholders or to reinvest back into the company. the board can divide to give shareholders a portion (or all!) of the retained earnings in the form of dividends. At the same time, the board also has the option to reinvest these funds.
When reinvesting, retained earnings can be used for a wide range of purposes including:
- Expanding the company’s physical presence
- Upgrading office and IT equipment
- Paying off high-interest debt
By having a clear picture of how much money the company has available, the owner and board can make the best financial decision for the company and its shareholders.
Shareholders care about the retained earnings statement because it shows how much equity they hold in the company. The higher the retained earnings amount, the more equity each shareholder has in the company. In essence, retained earnings are the total amount of money that a shareholder is entitled to receive, if the board decided to pay out some of the funds using dividends.
Using the total retained earnings number, shareholders can divide the amount by the number of shareholders to determine what their share is valued at.
External Impacts of Retained Earnings
Outside of the board and stakeholders, retained earnings are also important for investors and creditors. Investors who are interested in putting their money into a business will look at the company’s overall financials, to include retained earnings statements. Not only do investors care about how much retained earnings a company current has, investors also want to see how the fund amount has changed over the course of time.
By tracking retained funds, an investor can get a good idea of how much money they can expect to earn after investing in a business. The healthier your company’s retained earnings statements are, the more likely you are to find a solid and interested investor.
In the event that your company applies for funding in the future, creditors will also take a look at your retained earnings statements. While creditors examine various performance measures, retained funds statements are useful in determining a company’s ability to repay a loan.
Creditors are more likely to lend to a company that has a good history of retained earnings as it shows the business is making money and therefore has the cash flow to repay borrowed money.
Conclusion
As a small business, the statement of retained earnings not only shows the health and growth of your company, it also impacts shareholders, investors, and creditors.
