Understanding Equity: What Are Retained Earnings?

by Greg DePersio

2 min read

When preparing financial statements for a company, there are two essential types of accounts that need to be included: income statement accounts and balance sheet accounts. Income statement accounts show a company’s income and expenses and, ultimately, the profit for the reporting period. The balance sheet accounts show a company’s assets, liabilities, and shareholder’s equity at a given date. A key component of the shareholder’s equity portion of the balance sheet is the retained earnings. Their calculation can be presented in a separate statement, known as the statement of retained earnings.

The Composition of Retained Earnings

Simply defined, retained earnings are a company’s accumulated and undistributed profits over the years. Annual profits, as calculated in the statement of income, are transferred to the retained earnings account at the end of each reporting period, where they are added to the previous year’s ending balance. From there, any dividends paid during the year are subtracted, since dividends are a way of distributing profits out of a company, and the result is the new retained earnings balance. For example, assume company A has retained earnings of $100,000 at the end of year 1. In year 2, it makes a profit of $50,000 and pays dividends of $25,000 to its shareholders. Its new retained earnings are $100,000 + $50,000 – $25,000 = $125,000. If a company suffers a loss during a year, then the amount of the loss is transferred to the retained earnings, effectively diminishing them. It is possible for a company to have negative retained earnings. In such a case, it means that the company has been using shareholder capital, or debt, to pay for its operations. While this is frequent for startup companies, in the long run, it can be a sign of financial difficulties.

Preparing and Understanding a Statement of Retained Earnings

The presentation of a statement of retained earnings is straightforward. The company name is indicated at the top, followed by the words “statement of retained earnings” underneath and the date of the statement. The calculations are then presented, and the result is shown at the bottom. The information contained in the statement of retained earnings is a key indicator of a company’s financial health, and it can also be a sign of the company’s management style. As mentioned above, long-term negative retained earnings can be a sign of financial issues. Conversely, a company with large retained earnings would be expected to be in good financial health, since annual profits have probably been used in the company’s business to purchase assets. However, shareholders who want a steady dividend payout and notice that a company has large retained earnings along with important cash reserves could infer that the company’s management is prudent about paying dividends and prefers to keep cash on hand. This, by itself, is neither good or bad, but shareholders would be well-advised to inquire as to the reasons for this situation. Retained earnings should be viewed in the overall context of a company’s business. Startups, technology companies, and decades-old manufacturers have different numbers, but they can be an excellent basis for an assessment of a company’s overall financial health.

References & Resources

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