Retained earnings are an integral figure in any balance sheet. It is also a parameter of the company's growth and expansion strategy. Before we dive into retained earnings formula, we must understand what has retained earnings are and how it works for every organization.
Retained earnings are profits made in the past by a business, after subtracting any dividend it paid in its past. Here, the word "retained" shows that it is something kept aside from the rest. It means that the earnings were kept away by the company, and not distributed as dividends.
This is why retained earnings increase when the company earns a net profit. However, this item decreases when the company registers loss or pays dividends.
Learning how to find retained earnings is quite simple:
Retained Earnings = Beginning Period RE
+Net Income/Loss-Cash dividends-Stock dividends
Beginning Period RE: The retained earnings left after deducting dividends will carry forward to the next accounting cycle. It is the beginning period RE.
Net Income/ Loss: It is the accounting profit left after paying for all expenses. We arrive at this figure after subtracting COGS, SG&A, amortization, depreciation, and other such items from Sales Revenue. Any changes in net income/loss directly impact RE. If there are large net losses, then it will significantly reduce RE.
Cash dividend: The share of profit/accumulated profit a company chooses to distribute to its shareholders.
Stock dividend: When a company doesn't want to lose cash but still reward its shareholders, it distributes stock dividend. It is a dividend payment in the form of shares rather than stock. It doesn't reduce the cash, however, dilutes earnings per share.
In a balance sheet, retained earnings are written inside the equity section, because it is an equity balance.
Publicly trading companies have to show a movement of the company's equity balance as a supplementary statement. Here, the company shows beginning RE, items contributing to decrease/increase of retained earnings, and ending RE. Therefore, after you calculate retained earnings, it will be shown in the balance sheet (along with the calculation).
Time to apply retained earnings formula with an example.
Megaforce is a gym equipment company that has a beginning retained earnings balance of $8,000. It is the retained earning that has been carried over to the next accounting period. The company registered a net income of $5,500. It distributed $2,300 as a cash dividend. Therefore, here you will calculate retained earnings this way:
$8,000 + $5,500 - $2,300 = $11,200.
Therefore, the company has an ending retained earnings of $11,200.
Retained earnings are an integral part of the balance sheet, however, it doesn't provide meaningful insight to the company. Observing it for a long period (5-10 years) will only indicate how much a company has added to its retained earnings over time. Investors prefer dividends over a large accumulation of retained earnings.
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