Retained earnings are the portion of a company's net income that management retains for internal operations instead of paying it to shareholders in the form of dividends. In short, retained earnings are the cumulative total of earnings that have yet to be paid to shareholders. These funds arealso held in reserve to reinvest back into the company throughpurchases offixed assets or to pay down debt.
Key Takeaways
- Retained earnings (RE) is the surplus net income held in reserve—that a company can use to reinvest or to pay down debt—after it has paid out dividends to shareholders.
- When a company has positive profits, it will give some of it out to shareholders in the form of dividends, but it will also reinvest some of it back into the company for growth reasons.
- Any aspect of business that increases or decreases net income will impact retained earnings, including revenue, sales, cost of goods sold, operating expenses, depreciation, and additional paid-in capital.
How to Calculate Retained Earnings
Retained earnings (RE) are calculated by taking the beginning balance of RE andadding net income(or loss) and then subtracting out anydividendspaid.
For example: Let's assumeyou had the following numbers for a particular period:
- BeginningRE of$5,000 when the reporting period started
- $4,000 in net income at the end of the period
- $2,000 in dividends paid out during the period
To calculate the retained earnings at the end of the period:
Retained Earnings = RE Beginning Balance + Net Income (or loss)– Dividends
Retained Earnings = $5,000 + $4,000 - $2,000 = $7,000
ShareholderEquity Impact
Retained earnings are reported under the shareholderequity sectionofthe balance sheetwhilethe statement of retained earnings outlines the changes in RE during the period.
A company's shareholderequityis calculated by subtractingtotal liabilitiesfrom itstotal assets.Shareholderequity represents the amount left over for shareholders if a company paysoff all of its liabilities. To see how retained earnings impact shareholders' equity, let's look at an example.
Real-World Example
Below is the balance sheet for Bank of America Corporation (BAC) for the fiscal year ending in 2020. Shareholderequity is located towards the bottom of the balance sheet.
- Total shareholderequity was roughly $273 billion at the end of 2020.
- Retained earnings came in at approximately $164 billion.
- In the upcomingquarters, net income that's left over after paying dividends will be added to the $164 billion (assuming none of the existing retained earnings is spent during the quarter to pay debt or buy fixed assets).
- Both increases and decreases inretained earningsaffect the value of shareholders' equity.As a result, bothretained earnings andshareholders' equity areclosely watched by investors and analysts since these funds are usedto payshareholders via dividends.
:max_bytes(150000):strip_icc()/BOA-f8957c5ee9c14788b59a7e5edd802a7b.jpg "Which Transactions Affect Retained Earnings? (1)")
Source: Bank of America.
What Affects Retained Earnings
Revenueis the total amount of income generated by the sale of goods or services related to the company's primary operations. Revenueisthe income a company generatesbeforeany expenses are taken out.
Revenue, sometimes referred to as gross sales,affectsretained earnings since any increases in revenuethrough sales and investments boost profits or net income.As aresult of highernet income, more money is allocated toretained earningsafter any money spent ondebt reduction, business investment, ordividends.
Net income will have a direct impact on retained earnings. As a result, any factors that affect net income,causing an increase or a decrease, will also ultimately affect RE.
Factors that can boost or reducenet income include:
- Revenue and sales
- Cost of goods sold, whichis the direct costs attributable to the production of the goods sold in a company. Itincludes the costs of the materials used in creating the goods along with the direct labor costs involved in the production.
- Operating expenses, which are the costs incurred fromnormal business operations such asrent, equipment, inventory costs, marketing, payroll, insurance, and funds allocated for research and development.
- Depreciation, which is thecost of afixed asset spread outover its useful life.
Retained earnings areaffected by any increases or decreases innet income and dividends paidto shareholders. As a result, any items thatdrive net income higher orpush it lower will ultimately affect retained earnings.
With net income,there's a direct connection to retained earnings.However, for other transactions, the impact on retained earnings is the result of anindirect relationship.
Additional Paid-In Capital
Additional paid-in capitaldoes not directly boost retained earningsbut can lead to higher RE in the long term. Additional paid-in capitalreflects the amount of equity capital that is generated by the sale of shares of stock on the primary market that exceeds its par value.
The par value of a stock is the minimum value of each share as determined by the company at issuance. If a share is issued with a par value of $1 but sells for $30, the additional paid-in capital for that share is $29.
Additional paid-in capital is includedinshareholderequityandcan arise from issuing either preferred stock orcommon stock.The amount of additional paid-in capital is determined solely by the number of shares a companysells.
As a result, additional paid-in capital is the amount of equity available to fund growth.And since expansion typically leads to higher profits and higher net income in the long-term,additional paid-in capital can have a positive impact on retained earnings, albeit an indirect impact.
Are Retained Earnings Considered a Type of Equity?
Retained earnings are usually considered a type of equity as seen by their inclusion in the shareholder's equity section of the balance sheet. Though retained earnings are not an asset, they can be used to purchase assets in order to help a company grow its business.
What Are Negative Retained Earnings?
Negative retained earnings are a sign of poor financial health as it means that a company has experienced losses in the previous year, specifically, a net income loss. One year of negative retained earnings does not signal a company in complete poor financial health, but if retained earnings have consistently been negative, then a company has not been able to generate a profit for a long time.
Do Retained Earnings Carry Over to the Next Year?
Yes, retained earnings carry over to the next year if they have not been used up by the company from paying down debt or investing back in the company. Beginning retained earnings are then included on the balance sheet for the following year.
The Bottom Line
Retained earnings are the portion of income that a business keeps for internal operations rather than paying out to shareholders as dividends. Retained earnings are directly impacted by the same items that impact net income. These include revenues, cost of goods sold, operating expenses, and depreciation.
The higher the retained earnings of a company, the stronger sign of its financial health. This indicates that a company does enough business to generate revenues that cover all expenses (and that expenses are managed efficiently), pay out dividends if the company does so, and still has money left over to invest back into itself.
