Retained Earnings refer to the portion of the net income of the business that the business did not pay out as dividends. This means that the money stays in the ledger account until the business uses the money to reinvest it into the company or to pay future dividends. Hence, it is important to understand the revised earnings of the company since it helps the owners understand how much money is available for expansion or acquiring assets.
In this article, you will learn about retained earnings in general and what it means in the process of accounting. Next up, we will also explain the term to you with the help of a formula. Finally, we will check the impact of net income on retained earnings as well as the impact of dividends on retained earnings. Hence, to learn more about this accounting term, read on through to the end of the article.
What Are Retained Earnings?
According to Investopedia,
“Retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. As an important concept in accounting, the word “retained” captures the fact that because those earnings were not paid out to shareholders as dividends, they were instead retained by the company.”
Retained earnings refer to the net income of a company that is left over after the company has paid its dividends to investors or other distributors. The company thus retains the leftover amount. If there are surplus retained earnings, the business can choose to spend the money to further its growth.
After a company pays its dividends to its shareholders, the leftover profit is called retained earnings of the company. This amount provides the company with better clarity on how much money the business has after it paid off all its dues, including the share that investors claim.
At the time when the company is recording its retained earnings statements, there are changes in the value of retained earnings. Furthermore, when there are changes in the revenue and expense accounts, the value changes as well. In case the company incurs losses and pays dividends, the value decreases. However, it increases when the company records new profits.
How To Calculate Retained Earnings? – Formula
It is important to properly interpret the retained earnings of a company.
According to Indeed.com,
“A company’s retained earnings depict its profit once all dividends and other obligations have been met. If the retained earnings of a company are positive, this means that the company is profitable. If the business has negative retained earnings, this means that it has accumulated more debt than what it has made in earnings. When interpreting retained earnings, it’s important to view the result with the company’s overall situation in mind.”
Here is the formula to calculate retained earnings:
|Retained Earnings = Retained earnings in the beginning + Net Income (or Loss) − Cash dividends − Stock dividends|
Here, net income is the difference between the total expenses of the company and its total revenue. Some notable expenses include material costs, administrative expenses, general expenses, employees’ salaries, interests on debt, taxes, depreciation, and amortization.
Understanding Retained Earnings: What Do They Tell?
According to Wall Street Mojo,
“Retained earnings, as the name suggests, are the sum that a company retains after meeting all its financial liabilities, including the payment of the shareholders. This retained income is the amount companies use for reinvestment, which means utilizing the money back into the business. These earnings form a part of the shareholders’ equity section of the balance sheet.”
Basically, retained earnings are the company’s historical profits minus the dividends the company paid in the past. There can be situations of profit and loss for the company. If the company pays dividends to shareholders despite losses, the value of retained earnings decreases.
On the other hand, if the company earns profits, the value of retained earnings increases. Hence, its value keeps on changing based on the increase in value and decrease in value of revenue as well as expenses.
How Does Net Income Impact?
Net income directly impacts retained earnings. An increase or decrease in net income or the occurrence of a net loss of the company leads to the profitability of the business or deficit. If there is a large cumulative net loss, it can result in negative retained earnings.
Some of the examples of such items include sales revenue, cost of sold goods, depreciation, as well as other operating expenses. Other items like stock-based compensation and write-downs or impairments also affect the business account.
How Do Dividends Impact Retained Earnings?
A company can distribute its dividends in the form of cash or stock. Both forms of distribution of dividends reduce retained earnings. If the company makes cash payment of dividends, then there is cash outflow for the company, and the accountant records it as net reductions. If the company loses its liquid assets as cash dividends, it reduces the value of the company’s assets on the balance sheet. This leads to an impact on the retained earnings.
On the other hand, stock dividends do not require cash outflow. Here, the company reallocates a portion of retained earnings to common stock and additional paid-in capital accounts. This allocation does not impact the size of the company’s balance sheet overall. However, it decreases the value of stock per share.
Hope this article was helpful for you in getting a better understanding of what the retained earnings of a company mean. It is basically the amount of net income of the business that is left after the business pays out its dividends to its shareholders. The management of the company decides whether to retain the earnings or distribute the earnings among shareholders.
These earnings of a company are important to assess the company’s financial health. This is because these earnings show the net income that the company has saved over a period of time. Hence, the company gets the ability to reinvest in the business or distribute the money to its shareholders. If you have further info, consider sharing it with us in the comments section.