It's common for business owners to know how to determine sales and revenue, but some might not know how to calculate retained earnings. It's possible, too, that some business owners don't know exactly what retained earnings are.
Retained earnings may not even be relevant to smaller business entities such as sole proprietorships or single-member LLCs. Other businesses that have multiple owners or investors, though, will need to know how to calculate retained earnings, what they are, and the most common ways that they can be used.
As you'll soon see, retained earnings are something that any business owner would love to have—and have a lot of. Not only do retained earnings signal that a business is profitable, but they also provide an excellent opportunity to reward owners, launch a new product, and reinvest in the business.
What are retained earnings?
Retained earnings are defined simply as the total net income that's left over after all shareholders are paid dividends. Retained earnings only exist, then, if a company earns a profit. That's because dividends are only paid if there's money left over after all expenses are paid.
When a business has surplus money after all expenses are paid, this profit can be used in several ways. Unless specified in investment contracts, businesses don't have to pay dividends. Investors/owners can also all agree to forego receiving dividends in favor of using profits for other purposes.
Many investors/owners prefer to receive dividends when available, though, because many states allow dividends to be treated as tax-free income. Gains on stock earnings are subject to be taxed, on the flip side.
This is why it's important to delineate between profits and retained earnings.
How to calculate retained earnings
Business owners who want to know how to calculate retained earnings only need to understand a relatively simple formula.
Retained earnings are an ongoing calculation. In other words, you start the calculation by taking any retained earnings the company already has on hand, adding net income, then subtracting any cash and stock dividends.
Net income is simply all revenues a company has earned minus all interest, taxes, and expenses it incurs. Basically, it's the pure profit a company makes in a particular period.
Retained Earnings = Beginning Period Retained Earnings + Net Income - Cash Dividends - Stock Dividends
How to calculate retained earnings: an example
The easiest way to understand how to calculate retained earnings is by looking at an example with dollar amounts.
Let's assume that for this example, a business is attempting to calculate its retained earnings for the second quarter of 2020 (for April, May, and June).
This hypothetical business has four equal owners/shareholders and no outside investors. These owners have decided they will pay each person a 5% cash dividend out of each quarter's net income (if there is any). That means the business's total cash dividends will equal 20% of the net income.
Our example business also doesn't pay any stock dividends.
Keeping the above formula and abbreviations in mind, let's assume that our example business recorded these numbers for the second quarter:
Beginning Period Retained Earnings: $70,000
Net income: $35,000
Cash Dividends: $7,000 (20% of the net income)
Stock Dividends: $0
Therefore, to see how to calculate retained earnings for this hypothetical company, you'd complete this calculation:
Retained Earnings = $70,000 + $35,000 - $7,000 - $0
In this example, the company's retained earnings would be $98,000.
What can you reinvest retained earnings in?
A business can use retained earnings in several ways.
- First, owners can decide that they want to pay extra dividends. This could be a great option if there is an excess amount of retained earnings.
- A business may decide to distribute more dividends to reward shareholders after a very successful quarter, or as a quasi-bonus at the end or beginning of a calendar/fiscal year.
- Retained earnings are also commonly used to invest in expanding the business. This excess cash can help fund the cost of purchasing more inventory or hiring more employees to increase revenue even further.
- Retained earnings can be reinvested into the company in the form of technology and equipment that's necessary to launch a new product or service. They can even be used to purchase another business, to see a company through a merger, or to expand into new territory.
- Some businesses may choose to take retained earnings and pay down outstanding debt in the form of equipment leases, business credit card balances, or business term loans.
- Finally, retained earnings can also be kept on hand as cash reserves in case of unforeseen expenses or an unexpected dip in revenue. As the coronavirus pandemic has shown, it's never a bad idea to have extra cash on hand.
Retained earnings vs. shareholders' equity vs. revenue
Even though you now know how to calculate retained earnings, it's still very easy to get it confused with other accounting terms.
Two terms that are often confused with retained earnings are shareholders' equity and revenue. Revenue is directly related to retained earnings, while shareholders' equity is a separate calculation entirely.
Revenue is all income that a business generates from sales of its products/services. It's the amount of money a company brings in over a set period. It does not factor in any expenses that are incurred to generate that income.
Revenue must be taken into consideration when figuring out how to calculate retained earnings because it's used to calculate net income. Remember that net income is revenue minus all interest, taxes, and expenses.
Remember again that retained earnings are basically the accumulated profits for a company. It's the retained earnings the company earned for a particular time (for example, a quarter) plus the retained earnings it had at the beginning of that period.
Learn about revenue vs profit
Shareholders' equity, meanwhile, is a calculation that shows how much of the company each shareholder owns. A percentage can represent this at its base form, but it can also be calculated down to the dollar.
It is calculated by first figuring out what the company's total equity is. This is done by taking the company's total assets and subtracting its total liabilities. Then, you simply apply each shareholder's ownership percentage to figure out their individual equity.
Let's use our example above. Our hypothetical company had four equal owners/shareholders, so each one owns 25% of the company. If a company's total assets are $1 million, and its total liabilities are $500,000, then each individual shareholder's equity would be $125,000. It would be calculated this way:
$1 million (total assets) - $500,000 (total liabilities) = $500,000 (company equity)
$500,000 (Total equity) x 25% (shareholder percentage) = $125,000
Now you know how to calculate retained earnings
Many business owners are very familiar with revenues and expenses, but many may not know how to calculate retained earnings. While this accounting term is only truly applicable for businesses with multiple owners/shareholders, it's still something every business owner should be familiar with.
By understanding how to calculate retained earnings, you will be better prepared not only to see where your company stands, but also know what you can do with that money.
We at Camino Financial are always doing our best to help small businesses understand terms such as retained earnings. In addition to providing accessible small business loans. It's one way we help push small businesses forward and live up to our motto of "No Business Left Behind."
If you'd like to learn more ways that you can build a wildly successful small business, keep reading our article:
How to Increase Your Small Business Profit Margin