What is Retained Earnings and How Is It Calculated?

Let’s assume you are running a profitable clothing business and are left with a certain amount after covering all the expenses at the end of the year. This unspent amount is known as retained earnings, which can provide a cushion in tough times. 

Retained earnings are a powerful component in determining the complete trajectory of any business and are the first thing every investor and financier notices. If you want to learn more about it, read this blog to understand retained earnings definition.

What Does Retained Earnings Mean?

Every business has a portion of money not paid out as dividends or used in daily operations; it is called retained earnings. These are the funds that get saved after covering all expenses. You can utilize the money in investing, refinancing, managing debt, and expanding the services. 

RE is written in the equity accounting section of the balance sheet and depicts the financial health and stability of the company.  

Now that you’re introduced to this concept, read ahead as we simplify the term. 

How to Find Retained Earnings?

Retained Earnings can be calculated using the formula given below: 

RE= Net income during the FY + Beginning RE of the FY — Dividends 

Where, 

• RE stands for Retained Earnings 
• Net income is the total profit or loss of sales during that financial year. 
• Beginning RE is the retained balance available at the start of a specific period. 
• Dividends stand for the funds paid to the shareholders. 

Here’s an example of the retained earnings equation for a better overview.  

Consider these are the parameters of the company ARC:

Beginning RE= $100,000

Net Income= $50,000

Dividend= $20,000

Using the formula, the output is $130,000. This means the RE available for the ARC is $130,000. 

Importance of Retailed Earnings 

Retailed Earnings hold quite a significance as they directly display the company’s financial health. Here is why it matters so much:

• Indicates Stability: An increase in retailed earnings shows the company’s growth, while a decrease signifies that the company is going through a period of loss.
  
• Funds for Growth: Retained Earnings are the sum that a company can use for its expansion. Without having to go for external funding, these funds are for purchasing new equipment, research, and development, and expanding in new markets.
  
• Debt Management: Businesses having debt and liabilities can use these funds to pay off the balance. This way they can reduce debt and strengthen their balance sheet.
  
  Retained earnings can be counted as a pillar in the growth of the company. It can either break the deal with the investors or give significant benefits. 

Retained Earnings Vs Other Financial Metrics 

Business owners often confuse retained earnings with other financial terms like gross profit and dividends. However, retained earnings contribute to the company’s monetary growth in an entirely different way. Here’s how it differs from other financial metrics. 

Retained Earnings Vs Net Income 

Net income is the total earnings through sales in a period of time. It depicts the short-term phase, while retained earnings cumulate over time. 

Retained Earnings Vs Dividends 

Dividends are the amount given to the shareholders. They come under net income. Retained earnings, on the other hand, are the funds that is left in the balance holding after covering all expenses. 

Retained Earnings Vs Revenue 

Revenue is the total earnings a business makes in the financial year. RE is the funds left after all the expenditures and dividends. 

Factors Affecting Retailed Earnings?

Retailed Earnings can either increase or decrease over time with business operations. This depends on various factors. Every business owner needs to keep a check on these factors given below: 

• Profitability: Increased net income results in higher retained earnings, whereas ongoing losses diminish them.

• Dividend Policy: A company’s method of dividend allocation greatly influences retained earnings. Liberal dividends diminish retained earnings, whereas cautious strategies maintain them.

• Sector Standards: Industries that demand significant capital, like manufacturing or technology, generally keep a larger portion of their earnings to support expansion.

• Financial Circumstances: Economic recessions can result in diminished profits and, as a result, decreased retained earnings.

How Retained Earnings Influence Decision-Making?

Retained earnings play a pivotal role in the decision-making for the operation of the business. Here are the aspects that get influenced by: 

Investment Methods 

The management team of the company evaluates multiple investment opportunities and utilizes funds from high-profit sources. 

Dividend Decision 

When the company makes the budget to pay out dividends to the shareholders, retained earnings are what the finance department looks after. 

Financial Health 

The stakeholders, board of directors, and other investors look at the portion and ratio of retained earnings as a component to analyze financial stability. It highlights the long-term viability of the company. 

These are the aspects of the business that get most influenced and are dependent on the retained earnings ratio. 

How to Increase Retained Earnings?

Having a good portion of retained earnings is considered healthy for the financials of the company. There are certain ways by which you can increase them; here are some strategies: 

• Boost Income: Increasing revenue via marketing, product development, and market growth enhances net income and retained earnings.

• Lower Expenses: Optimizing operations, negotiating supplier agreements, and implementing cost-reducing technologies improve profitability.

• Enhance Dividend Strategies: Aligning dividend distributions with reinvestment requirements promotes steady growth and robust retained earnings.

• Handle Debt Efficiently: Lowering debt responsibilities decreases interest costs, boosting net income and retained earnings.

Using the above-given formulas, you can make proper strategies to boost your retained earnings. 

Limitations of Retained Earnings 

Even though retained earnings boast many positive points, they also have some underlying drawbacks. Here are the major ones: 

• Improper Handling of Finances: Mismanagement of retained earnings, like investing in low-return initiatives, can obstruct growth and profitability.

• Expectations of Shareholders: Investors might urge firms to raise dividend distributions, leading to a decrease in retained earnings for reinvestment.

• Adverse Public Viewpoint: Holding onto too much profit without evident growth plans might lead investors to worry about the company’s strategic path.

These are the pitfalls that you must keep in mind about the retained earnings equation. 

We have covered everything about retained earnings, its formula, equation, benefits, and limitations. We hope this blog has clarified your doubts and explained the concept well. Share it with your friends and family to make them aware too!