September 09, 2019

Why should you pay attention to the retained earnings line on the balance sheet?

Bookkeeping-101

What is bookkeeping?

Your balance sheet is a snapshot of your business’s financial data at a specific point in time. It provides a detailed list of your assets, liabilities and the value of your shareholders’ equity. In short, it’s indicative of the overall financial health of your business. It’s important to understand your balance sheet, (which is called ‘balance sheet’ because your assets must always equal your liabilities plus shareholders’ equity). Once you become familiar with reading and interpreting your balance sheet, it can alert you to any red flags that threaten the financial viability of your business such as high debt relative to cash flow and low cash balance.

Where can I find retained earnings on the balance sheet?

When reading your balance sheet, you’ll find retained earnings included under liabilities in the equity section. This is because net income as shareholder equity is a debt of the company/corporation in relation to its owners. Shareholder equity can be reinvested into the company or it can be distributed among shareholders as dividends paid. When compiling a financial strategy for your business, accumulating retained earnings should prioritized for long-term business stability and growth. Below-mentioned is an example of shareholder equity, including retained earnings, detailed on the balance sheet, (note that the term ‘stockholders’ equity’ is synonymous with the term ‘shareholders’ equity’).

What is Balance Sheet?

What does the retained earnings line on the balance sheet mean?

Retained earnings are net profit (revenue and income streams minus expenses) remaining after dividends paid to shareholders and investors at the end of a reporting period. The way you manage your net profit over time – particularly retained earnings – is an important consideration for potential lenders and investors. Your statement of retained earnings is vital when applying for a loan or investment funding because it gives investors insight into how healthy your business is and what your business intentions are. Positive retained earnings indicate a commitment to overall growth whereas negative retained earnings are indicative of net loss and an accumulative deficit.  

The retained earnings are listed under ‘Shareholders’ Equity’, (sometimes also referred to as shareholder equity / stockholders’ equity), as per the example of a balance sheet shown above, but what exactly is meant by the term? Shareholders’ equity is the difference between total assets and total liabilities. It’s the share of owners or residual claim after all debts have been paid. Retained earnings form part of the shareholder equity; it’s the percentage of net income not distributed as dividends paid. 

In the equity section of the balance sheet, there are two categories: common stock and retained earnings. The equity, or common stock, is the stock held by founders or the initial investment of shareholders in the corporation. On the balance sheet, assets=liabilities + shareholders’ equity. Shareholders’ equity is comprised of common stock + retained earnings. These retained earnings may be used as dividends paid, to pay off debt or to generate revenue via business growth. See the model below:

What does the retained earnings line on the balance sheet mean?

If your business makes a profit, you can choose to pay the money to your shareholders as a cash dividend or you can keep the earnings to reinvest in the business in a process known as retained earnings. When you choose to use net income, (also known as net profit) as retained earnings, you have the opportunity to grow and develop your business. Retained earnings may be used for:

  • Business expansion
  • Research and development
  • Marketing initiatives
  • Paying off debt

The retained earnings line on your balance sheet shows investors and lenders that net income is being utilized for long term business growth.  

The equity section of the balance sheet also provides significant insight into business cash flow. Net income, that is, the resulting figure of revenue including expenses such as cost of goods sold (COGS), operating costs, payment of debt, interest on loans and accrued from investments, additional income streams from the sale of assets or from subsidiary holdings, depreciation and amortization of assets and taxes, represents positive cash flow. If your business has a positive cash flow, there’s more cash coming into the business than going out. As it flows through your business, you’ll be able to pay your expenses, return money to shareholders and retain earnings for the future. 

Back to the equity section of the balance sheet: shareholders’ equity may originate from the initial investment in the business by investors or owners, or it may come from retained earnings where net income is reinvested. The shareholders’ equity section of the balance sheet also provides essential information regarding the share capital of the company/corporation including types of shares, their nominal value, number of shares authorized for issue, number of shares issued and outstanding shares. The balance sheet is one of the most informative financial statements for use internally within the business or externally for lenders and potential investors. It’s vital that a business owner has a basic understanding of how to read and interpret their  balance sheet in order to maximize profit, achieve business growth and identify and overcome red flags or cash flow issues.  

As a business owner, it can be difficult to find the time to sit down and try to interpret financial information – particularly if you don’t have an interest in ‘crunching numbers’, so to speak. Although you have the awareness that it’s important to understand your balance sheet, you’re too busy focusing on providing a quality product or service and don’t have the time to spend trawling through financial statements. Let us help you, we’re passionate about providing you with personalized reports that are easy to understand while providing you with all the essential information you need.  

How are the retained earnings calculated on the balance sheet?

The formula for retained earnings is RE 1 = RE 0 + NI – D

  • RE 1 – net income at the end of the reporting period 
  • RE 0 – net income at the beginning of the period 
  • NI – net income minus income tax
  • D – Dividends paid 

Retained earnings are cumulative, meaning that they’re reported on your balance sheet in the equity section, and RE 0 is carried over from the retained earnings of the previous reporting period. As retained earnings are listed under the shareholders’ equity, an increase to retained earnings similarly increases the liabilities side of the balance sheet. Shareholder equity is considered to be a liability to the company/corporation as it represents a claim of the owners or shareholders in relation to the company.  Retained earnings are affected by cash flow such as net income or expenses and dividends, therefore, an increase or decrease in these accounts will similarly affect a business’s retained earnings. Another way that retained earnings are affected on the balance sheet is via dividends paid; if it’s decided that the company will retain a larger portion of net income to reinvest back into the company, the dividends paid to shareholders will be reduced and vice versa. In this way, the motivation or decisions made by the business owner or decision makers is reflected in the financial statements, and changing motivations are able to be assessed over time through cumulative financial statements. In turn, the motivation of the business owner / decision makers will affect net income and therefore, retained earnings. 

BooksTime can help you to understand your balance sheet and how your retained earnings are affected by your cashflow

Your BooksTime bookkeeper won’t only help you to manage your financial data, they’ll also help you to understand and use your data to grow your business. We understand that whilst you know that your balance sheet and financial statements are vital, the daily demands of running a business, managing staff, attending to orders, undertaking marketing and relating to your customers/clients are the priority. Thinking about sitting down in front of your balance sheet and considering your retained earnings after a long day in the office/shop/store/behind a computer can be overwhelming and unappealing. Your priority as a business owner is in growing your business, and that involves focusing on your specialization. Let us take the hard work out of interpreting financial data and using it to obtain strong and consistent business growth. We can provide you with:

  • Monthly reports to give you a clear and accurate view of your finances.
  • The ability to track trends that matter to you most with customized visual dashboards.
  • Customized cash flow forecasts to assist you to plan for the future.
  • High level consulting finance guidance to provide you with financial leadership, help you to design a financial strategy, prepare presentations to impress prospective lenders and investors and advise on M&A initiatives.

We are also able to automate your bookkeeping, and can provide you with your own personalized bookkeeper who is specialized in your industry, so that you don’t need to worry about coming home and tending to ‘the books’. Our services are cost effective – BooksTime uses the latest technology to streamline many common bookkeeping tasks so that we can offer prices that are 20% to 50% lower than other bookkeeping services. We even offer a Best Price Guarantee. 

If you have any questions about retained earnings, or your balance sheet, or if you would like to book a free consultation with us, complete this form and we’ll be in contact with you within 24 hours. 

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