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A simplified definition: Business owners use retained earnings as an indication of how they’re saving their company earnings.
Retained earnings are a clearer indicator of financial health than a company’s profits because you can have a positive net income but once dividends are paid out, you have a negative cash flow.
Where to find retained earnings in the balance sheet?
In terms of financial statements, you can find your retained earnings account (sometimes called Member Capital) on your balance sheet in the equity section, alongside shareholders’ equity. In rare cases, companies include retained earnings on their income statements.
Your bookkeeper or accountant may also be able to create monthly retained earnings statements for you. These statements report changes to your retained earnings over the course of an accounting period.
How to calculate retained earnings
The retained earnings formula is fairly straightforward:
Current Retained Earnings + Profit/Loss – Dividends = Retained Earnings
Your accounting software will handle this calculation for you when it generates your company’s balance sheet, statement of retained earnings and other financial statements.
If you happen to be calculating retained earnings manually, however, you’ll need to figure out the following three variables before plugging them into the equation above:
- Your current or beginning retained earnings, which is just whatever your retained earnings balance ended up being the last time you calculated it. (If you create a balance sheet monthly, for example, you’ll use last month’s retained earnings.)
- Your net profit/net loss, which will probably come from the income statement for this accounting period. If you generate those monthly, for example, use this month’s net income or loss.
- Any dividends you distributed this specific period, which are company profits you and the other shareholders decide to take out of the company. When you issue a cash dividend, each shareholder gets a cash payment. The more shares a shareholder owns, the larger their share of the dividend is.
Not sure if you’ve been calculating your retained earnings correctly? Try a bookkeeping service like Bench. We’ll pair you with a bookkeeper to calculate your retained earnings for you so you’ll always be able to see where you’re at.
Example of a retained earnings calculation
Let’s say your company went into business on January 1, 2020. Your retained earnings account on January 1, 2020 will read $0, because you have no earnings to retain.
Now let’s say that in January you earn $1,000 in net income (from your income statement) and don’t issue any dividends.
That means that on February 1, your company’s retained earnings will be $1,000:
Current retained earnings + Net income - Dividends = Retained earnings
$0 + $1,000 - $0 = $1,000
This makes sense: you earned $1,000 in profits, and retained all of them.
How to calculate the effect of a cash dividend on retained earnings
Here’s a more complex example of retained earnings calculation. To raise capital early on, you sold common stock to shareholders. Now your business is taking off and you’re starting to make a healthy profit which means it’s time to pay dividends.
Once your cost of goods sold, expenses, and any liabilities are covered, you have to pay out cash dividends to shareholders. The money that’s left after you’ve paid your shareholders is held onto (or “retained”) by the business.
Now let’s say that the business does really well in February, and you make an enormous profit that month: $10,000. You’re doing so well that at the end of February, you decide to pay out $2,000 of those profits in the form of cash dividends to your shareholders (you, your mom and your aunt Karen). And remember, the beginning balance for retained earnings will be $1,000.
That means that on March 1, your retained earnings will be $9,000:
Current retained earnings + Net income - Dividends = Retained earnings
$1,000 + $10,000 - $2,000 = $9,000
How to calculate the effect of a stock dividend on retained earnings
Sometimes when a company wants to reward its shareholders with a dividend without giving away any cash, it issues what’s called a stock dividend. This is just a dividend payment made in shares of a company, rather than cash.
Calculating retained earnings after a stock dividend involves a few extra steps to figure out the actual amount of dividends you’ll be distributing.
First, you have to figure out the fair market value (FMV) of the shares you’re distributing. Companies will also usually issue a percentage of all their stock as a dividend (i.e. a 5% stock dividend means you’re giving away 5% of the company’s equity). So you have to figure out exactly how many shares that is.
Put in equation form, the formula for retained earnings in a stock dividend is:
Current retained earnings + Net income - (# of shares x FMV of each share) = Retained earnings
Example of a stock dividend calculation
Let’s say that in March, business continues roaring along, and you make another $10,000 in profit. Since you’re thinking of keeping that money for reinvestment in the business, you forego a cash dividend and decide to issue a 5% stock dividend instead.
Let’s say your company has a total of 10,000 outstanding shares of common stock, and you determine that the fair market value of each share is $10. That means you would issue 500 shares in the dividend, each of them reducing retained earnings by $10:
Current retained earnings + Net income - (# of shares x FMV of each share) = Retained earnings
$9,000 + $10,000 - (500 x $10) = $14,000
This means that on April 1, retained earnings for the business would be $14,000.
Retained earnings, shareholders’ equity, and working capital
Your company’s balance sheet may include a shareholders’ equity section. This line item reports the net value of the company—how much your company is worth if you decide to liquidate all your assets.
Shareholders’ Equity = Total Assets − Total Liabilities
Retained earnings are not the same as shareholders’ equity. Retained are part of your total assets, though—so you’ll include them alongside your other liabilities if you use the equation above.
Shareholders equity—also stockholders’ equity—is important if you are selling your business, or planning to bring on new investors. In that case, they’ll look at your stockholders’ equity in order to measure your company’s worth.
Also, keep in mind that the equation you use to get shareholders’ equity is the same you use to get your working capital. Working capital is the value of all your assets, minus liabilities. It’s a measure of the resources your small business has at its disposal to fund day-to-day operations.
Significance of retained earnings in attracting venture capital
Retained earnings provide a much clearer picture of your business’ financial health than net income can. If a potential investor is looking at your books, they’re most likely interested in your retained earnings.
Why? Things like revenue and expenses can fluctuate month-to-month. If an investor is looking at December’s financial reporting, they’re only seeing December’s net income. But retained earnings provides a longer view of how your business has earned, saved, and invested since day one.
Up-to-date financial information and retained earnings
Up-to-date financial reporting helps you keep an eye on your business’s financial health so you can identify cash flow issues before they become a problem.
Your Bench account’s Overview page offers an at-a-glance summary of your income statement and balance sheet, allowing you to review your profitability and stay on top of your cash flow from month to month. Spend less time figuring out your cash flow and more time optimizing it with Bench.
