Want to know the secret behind a company’s financial health? The statement of retained earnings is your go-to source! It reveals how much profit is being reinvested into the business versus paid out to shareholders. Whether you’re an investor, entrepreneur, or just a numbers enthusiast, understanding this statement unlocks a deeper insight into business growth.
The statement of retained earnings, it might sound like a dusty, complicated accounting term, but it’s actually one of the most telling documents about a company’s financial health.
Think of it as peeking into the company’s piggy bank to see how much profit has been saved up over time, rather than paid out to shareholders. It tells a story about the business’s choices, whether it’s ploughing money back into growth or handing it out as dividends.
Whether you’re a business owner wondering how your profits are really stacking up, an investor curious about a company’s future, or just someone who loves making sense of numbers, understanding this statement sheds light on the bigger picture.
But why it matters, and how it can be revealed, let’s get started.
The Basics: Retained Earnings
Before we get into the statement itself, let’s understand what retained earnings actually are.
Think of a business’s retained earnings as the company’s savings account. It’s the cumulative profit a business keeps after it’s paid out dividends to shareholders. Instead of handing out all its earnings, a company tucks some away to reinvest into operations, fund new projects, or cushion itself in tougher times.
In other words, retained earnings are profits that have been retained for the company’s use, not handed out.
At the end of each accounting period, you’ll find retained earnings on the balance sheet under the shareholders’ equity section. This figure represents all earnings amassed since the company’s inception, minus any dividends paid out along the way.
What is the Statement of Retained Earnings?
So what exactly is the statement of retained earnings?
Picture it as a quick yet insightful summary of what’s happened to those retained profits over a specific period (usually a month, quarter, or year). This statement outlines:
- The retained earnings at the start of the period (which is simply last period’s ending balance).
- The net income or profit earned by the company during the period.
- Any dividends paid out to shareholders.
- The calculations that connect these figures and result in the final retained earnings balance at period’s end.
Sometimes lumped into other statements, the statement of retained earnings can be a standalone document or embedded within the balance sheet or income statement. Regardless, its importance never diminishes.
Read more: Statement of Retained Earnings: Why It Matters in Financial Reporting
Why Does the Statement Matter?
You might be thinking, “Isn’t this just an internal record? Why should anyone else care?”
Here’s where it gets interesting.
Investors, lenders, and the business owners themselves all scrutinise this statement because it provides clues to the business’s health and trajectory. A strong, steadily growing balance hints at strategic reinvestment and a company with ambitions for growth.
Meanwhile, negative or dwindling retained earnings can set off alarm bells, a sign perhaps of losses, excessive payouts, or shaky financial management.
For banks considering lending money or investors weighing up a new stake, a positive track record of retained earnings boosts confidence in the business’s stability and future potential.
The Formula: Breaking It Down (No Maths Degree Required)
Let’s put it simply. Here’s the formula at the heart of every statement of retained earnings:
Ending Retained Earnings=Beginning Retained Earnings+Net Income (or Loss)−Dividends Paid
Let’s break this down:
- Beginning Retained Earnings: The amount carried over from the previous period.
- Net Income (or Loss): How much profit (or loss) the business generated.
- Dividends Paid: Amount given to shareholders.
Pop these values into the equation, and voilà – you get the retained earnings at the end of your chosen period.
Tip: Ensure the beginning balance matches the previous period’s ending balance. Recording errors or inconsistent statements can wreak havoc, leading to confusion and inaccurate analysis.
For Example
To bring the concept to life, let’s use a simple example.
Suppose a bakery started with $40,000 in retained earnings at the beginning of the year. During the year, it earned $15,000 in profit and paid out $5,000 in dividends.
Ending Retained Earnings=$40,000+$15,000−$5,000=$50,000
That’s it! The bakery now boasts $50,000 in retained earnings moving into the next year, reflecting it kept $10,000 of its profits after rewarding its shareholders.
Why Not Always Positive?
Here’s a little twist, not all businesses have positive retained earnings.
In fact, it’s possible (and not uncommon) for retained earnings to be negative. Perhaps due to substantial losses or large dividends, the retained earnings account can dip below zero, a situation called an accumulated deficit.
While not ideal, it’s a sign to seek out the root causes, review strategies, and, if necessary, tighten the financial belt.
Retained Earnings vs. Dividends: The Push and Pull
Retained earnings and dividends are like two ends of a see-saw. When a company earns a profit, it has a choice: dole some (or all) of it out as dividends, or hold onto it for future needs.
A business hungry for expansion may favour retaining more, while a mature company might spoil shareholders with generous dividends. The right balance depends on the company’s strategic goals, age, industry norms, and owner philosophy.
Where Do Retained Earnings Go?
So, what does a company do with retained earnings? Here are some common uses:
- Reinvestment: From buying new equipment to hiring staff and opening new locations, reinvesting back into the business fuels growth.
- Debt Repayment: Paying off loans or other obligations ensures long-term stability.
- New Products or Services: Funding research, development, or new launches to stay ahead of competitors.
- Mergers and Acquisitions: Joining forces with or acquiring other businesses.
- Stock Buybacks: Occasionally, companies use retained profits to buy back their own shares, often to boost share value.
Reading and Analysing the Statement
Now, let’s talk about what you’ll notice when you look at a statement of retained earnings.
- Trend Analysis: Are retained earnings consistently growing? That’s typically a positive sign.
- Relationship to Dividend Policy: Big, regular dividends might suppress growth in retained earnings, even if the business is profitable.
- Red Flags: Erratic swings or persistent negative retained earnings might require a closer look.
Investors and analysts often look not just at the size of retained earnings, but also at something called the retention ratio or plowback ratio, which is the proportion of profit kept (not paid as dividends):
A higher ratio signals the company is working to build a stronger foundation for future reinvestment.
When and Where Will You See It?
Not every business issues a separate statement of retained earnings. Smaller companies or those with less sophisticated financials might simply include the information on the bottom of their income statement or as part of the equity section on the balance sheet.
Larger, publicly traded companies often issue a dedicated statement, especially in line with regulatory requirements.
How to Prepare a Statement of Retained Earnings
Fancy having a go at preparing one yourself? Here’s a step-by-step guide:
- Start with the last period’s retained earnings (or zero, if just starting out).
- Add net profit (from the income statement) or subtract net loss.
- Subtract any dividends (cash or stock) paid to shareholders.
- Present the resulting figure—this is your ending retained earnings.
For extra clarity or to impress potential investors, arrange these calculations in a neat table or spreadsheet, making the process transparent and easy to follow.
Frequently Asked Questions
- Do stocks appear on the statement of retained earnings?
Ans. No. While dividends might reduce retained earnings, the actual value of a company’s issued shares is accounted for elsewhere, in the shareholders’ equity section of the balance sheet. - Are dividends always paid out of retained earnings?
Ans. Typically, yes. Retained earnings are “left over” after dividends have been distributed, but the act of paying dividends itself reduces the retained earnings figure. - Can you work out retained earnings from the cash flow statement?
Ans. Not directly, as cash flow statements focus on cash movements, while retained earnings also account for non-cash items such as accrued income or unpaid expenses. - Why the Statement Is Worth Your Attention
Ans. A statement of retained earnings isn’t just a dry exercise for accountants – it’s a snapshot of a company’s decision-making, growth ambitions, and financial resilience. Reviewing changes in retained earnings offers insights far beyond raw profit numbers:
- Does the company reward shareholders now, or invest for tomorrow?
- Is management consistent in its approach, or does it make erratic decisions with profit?
- How has the business weathered thick and thin over the years?
Himani Verma is a seasoned content writer and SEO expert, with experience in digital media. She has held various senior writing positions at enterprises like CloudTDMS (Synthetic Data Factory), Barrownz Group, and ATZA. Himani has also been Editorial Writer at Hindustan Time, a leading Indian English language news platform. She excels in content creation, proofreading, and editing, ensuring that every piece is polished and impactful. Her expertise in crafting SEO-friendly content for multiple verticals of businesses, including technology, healthcare, finance, sports, innovation, and more.
