Q: What do you call a friend who loves Math?
Accounting folks, in this article, you have to unleash the algebro in you and learn to solve the mystery there is in retained earnings.
If you ever saw a balance sheet, you must have encountered the term, retained earnings in the equity section. But have you ever figured out what it is really for?
If in case “balance sheet” does not ring a bell to you, let us have a fast check.
One of the three rudimentary financial statements is the balance sheet. In this one, all-important layer lies the most significant figure of the business – net worth. The balance sheet reflects the totality of the company’s assets and how these assets are financed through credit and/or equity.
A balance sheet is called a balance sheet for nothing. Mostly, it shows the balance between revenues and expenses accumulated over time. On the one hand, it shows your total assets by combining current assets and non-current assets.
On the other hand, it exposes the company’s total liabilities by combining current obligations and non-current liabilities plus the total equity comprised by share capital and retained earnings.
So, how do retained earnings come into the picture?
Retained Earnings Defined
A company’s profit is usually distributed to their stockholders as dividends or return of investment and whatever is left become retained earnings. If a business does not give dividends, the entire income becomes the retained earnings.
Companies usually keep their retained earnings (as it is supposed to be) as the previous earnings are added up to the current one. These earnings are used to pay balances or even buy properties and sometimes, make it a working capital to expand the business.
Under shareholders’ equity, retained earnings sometimes show radical movements in the cash flow, as seen in periodic financial statements due to the two impactful factors in net income and dividends.
Calculating Retained Earnings
But how do we compute retained earnings?
The formula is quite simple.
Previous Retained Earnings plus profit or loss minus dividends equals Retained earnings.
(PRE +Profit/loss – Dividends = RE)
For instance, you decided to put up a self-managed bakeshop. Your previous retained earnings would be automatically $0 since you have just started your business. If you earn a profit amounting to $100 after a month, you now have retained earnings worth $100. Let us break it down.
Previous Retained Earning = $0
Profit = $100
Dividends = $0
Thus, $0 + $100 – $0 = $100
Bringing Dividends in the Equation
Now, let us insert dividends in the equation. Suppose your best friend lent you $100 to add to your working capital to bake more cakes. Then, your orders started increasing as well as your expenses and other liabilities. After another month of operation, you earned $200 profit. But you are going to give some of it as your best friend’s return of investment for $20 initially.
Given the amount of retained earnings from the first situation, let us compute once more your retained earnings.
Previous Retained Earnings =$100
Profit = $200
Dividend = $20
Retained Earnings: $280
Retained Earnings or Net Profit?
Now, you might wonder and ask, “How is net profit different from retained earnings if they’re both pointing to my business income?”
Well, retained earnings and net profit are almost, but not quite, the same.
Think about a time when your net profit materialized while your retained earnings didn’t, and the exact opposite of it (you have retained earnings but no net profit). Is that even feasible? Yes, because your net profit is the difference when you subtract your expenditures from your revenues. Meaning to say, your expenses were more significant in value than your taxes.
Retained earnings are the remaining income of your business after shelling out the dividends to the shareholders plus your previous retained earnings. Your retained earnings may be harmful for a specific business period because the value of your profits was higher than your earnings.
Remember, retained earnings are the sum of previous retained earnings and profit minus your dividends paid.
Reporting Issues in Retained Earnings
In calculating retained earnings, several issues might affect the statement. Let’s probe some of them.
Controlling forces affecting a sudden increase in retained earnings:
(+) Net income
(+) Switch in accounting principle applied
(+) Prior period adjustments
Meanwhile, here are the other external forces affecting a sudden decrease in your retained earnings:
(-) Net loss
(-) Switch in accounting principle applied
(-) Prior period adjustments
Retained Earnings – To keep or not to keep?
To keep or not to keep – that is the question.
Young business managers usually face this dilemma of keeping their retained earnings or using it to acquire assets for the chance of making more significant revenues in the process or maybe rewarding stockholders with more substantial dividends.
If you are on the keep side of things, how much retained earnings should you keep? Paradoxically, in this case, calculating retained earnings would be a much easier task than calculating how much retained earnings you would want to hold off.
In retrospect, it is wise to hold off retained earnings if you consider the bigger picture that your company might need those earnings soon for investments. But stockholders on the other end would demand larger dividends as the retained earnings accumulate.
But entrepreneurs must realize that it is one factor that destabilizes the company’s total assets that sometimes, might turn into negative retained earnings. Open communication and good investment policy must be observed between parties to avoid precarious financial situations.
Moreover, at times, there are mandated restrictions on retained earnings. These restrictions can be classified into two: internal restriction and external restriction.
For example, you plan to plant business assets like procuring equipment for additional operation. Your shareholders then must come into agreement to hold off a particular amount of retained earnings to be able to purchase the equipment even at the expense of them getting sustained or relatively lower dividends.
External restriction, on the other hand, is when a financing or lending institution your company tied up with (i.e., a commercial bank) would require you to maintain a retained earnings threshold to serve as your company’s collateral in case your business health turns weak.
Retained Earnings as your main asset
If you think your net profit makes your business financial health look good, think twice.
Your retained earnings can be a better indicator of how your business fares over the years. Sometimes, a good deal of retained earnings becomes an asset to get a prominent potential investor, all because retained earnings provide a bigger, wider, and better view of how your business has grown and earned since then.
Why calculate retained earnings?
Calculating retained earnings is an integral activity that companies should maintain doing efficiently, especially when they want to strategize for business growth and expansion.
Serving as a reserve resource and contingency budget, companies will have the luxury to explore and venture to broader business paradigms and marketing research to advance their existing system.