Retained Earnings Explained
Sometimes referred to as Member Capital, retained earnings refer to the amount of profits retained by the business after the distribution of dividends and other related payments. The retained earnings line is located in the Equity section of the balance sheet.
How to Calculate Retained Earnings
o calculate retained earnings you need to start with the retained earnings figure for the start of the accounting period and add it to the period’s Profit/Loss figure and then subtract any dividends paid to arrive at your new retained earnings figure. The formula looks like this.
Start Paid Earnings + Profit/Loss – Dividends = Retained Earnings
A simple demonstration of this calculation would be the following scenario.
Let’s say you started a new business and earned a profit of $15000 in the first year.
Your beginning retained earnings would be zero
Your Profit would be $15000
As you have made no distribution of profit your retained earnings would be $15000.
Now, let’s look at a scenario where you did make profit distributions in the form of dividends.
Retained Earnings With Dividends
After your business is well established and you start to see consistent profits, it may be prudent to start rewarding the shareholders of your business with some dividends for their investment.
Any profit that remains in the business after the distribution of dividends will become retained earnings.
If we follow on from the scenario above, we can imagine a situation such as this.
Beginning Retained Earnings: $15000
$15000 + $45000 – $35000 = $25000 retained earnings
How Do Retained Earnings Differ From Net Profit?
There is a clear distinction between retained earnings and net profit, which at first glance appear to be quite similar.
Net Profit is a calculation of how much money the business has made for a set period after accounting for all revenue and expenses. By comparison, retained earnings are what profit is left in the business after factoring in the retained earnings starting point and the distribution of dividends. In effect this means that there may be times when your net profit increases and your retained earnings decrease and vice versa.
A situation like the following scenario is not uncommon.
Your business has made a net profit of $100000. However over the course of the accounting period, dividends have been paid to three shareholders totaling $105000. The net profit of $100000 is positive but the retained earnings figure’s movement will be negative (Net profit – Dividends = Retained earnings) and is actually -$5000
When Should You Use Retained Earnings
When you start to see an increase in profits and are unsure of how to use them, it’s a good idea to review your retained earnings numbers. If the number isn’t particularly high and/or your business is still in its infancy, the safe option is to retain the extra profits in the business and resist the temptation to pay out large dividends.
If your net profit and retained earnings numbers are both strong, there may be an opportunity to invest some of your retained earnings in to the business. If you are looking to expand your operations and upgrade business infrastructure, retained earnings can be a good source of funds to cover expenses not associated with the day to day running of the business.
Why is Retained Earnings Important?
Retained earnings are a great way to get a clear picture of the business’ performance over the long term. Potential investors are likely to place more emphasis on the retained earnings figures of the business than the actual net profit.
This is because revenue and expense figures can vary over time and net profit provides a snapshot of business performance at a point in time. Retained earnings can provide an indication of how the business has performed from its inception.