What is a statement of retained earnings?
A statement of retained earnings shows the changes in a business’ equity accounts over time. Equity is a measure of your business’s worth, after adding up assets and taking away liabilities. Knowing how that value has changed helps shareholders understand the value of their investment.
The statement of retained earnings is one of four main financial statements, along with the balance sheet, income statement, and statement of cash flows. In smaller companies, the retained earnings statement is very brief. In that case, the company may choose not to issue it as a separate form, but simply add it to the balance sheet. It’s also sometimes called the statement of shareholders’ equity or the statement of owner’s equity, depending on the business structure.
What does the statement of retained earnings include?
The structure/formula of the statement of retained earnings is:
Beginning retained earnings + Net income – dividends = Ending retained earnings
The statement of retained earnings starts with the beginning balance in the retained earnings account, then:
- adds increases to the account from net income (or decreases due to a net loss)
- subtracts decreases to the account due dividends
The result is the ending retained earnings balance.
Benefits of the statement of retained earnings
The statement of retained earnings can help investors analyze how much money the company’s shareholders take out of the business for themselves, versus how much they’re leaving in the company to be reinvested.
This analysis may include calculating the business’ retention ratio. The retention ratio (also known as the plowback ratio) is the percentage of net profits that the business owners keep in the business as retained earnings.
You can calculate the retention ratio as follows:
Retention ratio = (Net Income – Dividends) / Net Income
A low retention ratio isn’t always a bad sign. It depends on how the ratio compares to other businesses in the same industry. A service-based business might have a very low retention ratio because it does not have to reinvest heavily in developing new products. On the other hand, a startup tech company might have a retention ratio near 100%, as the company’s shareholders believe that reinvesting earnings can generate better returns for investors down the road.
For a real-world example, look no further than Apple. Between 1995 and 2012, Apple didn’t pay any dividends to its investors, and its retention ratio was 100%. In 2012, the company started paying dividends. But it still keeps a good portion of its earnings to reinvest back into product development. The company typically maintains a retention ratio in the 70-75% range.
Statement of retained earnings example
The following example shows a simple statement of retained earnings:
Winnie’s Web Design, LLC
Statement of Retained Earnings
For the Year Ended December 31, 2020
|Retained earnings at December 31, 2019||$95,000|
|Net income for the year ended December 31, 2020||45,000|
|Dividends paid to shareholders||- 15,000|
|Retained earnings at December 31, 2020||$125,000|
How to prepare a statement of retained earnings
To prepare the statement of retained earnings, you need the following information:
Opening balance retained earnings. You can usually find this information on the previous year’s balance sheet or the opening balance of the retained earnings account in your general ledger.
Net income for the current period. This is the bottom line of the company’s income statement.
Dividend payments. Dividends paid out during the period should appear as a use of cash under Cash Flows from Financing Activities on the cash flow statement.
Once you have all of that information, you can prepare the statement of retained earnings by following the example above. When you’re through, the ending retained earnings should equal the retained earnings shown on your balance sheet.
If your company is very small, chances are your accountant or bookkeeper may not prepare a statement of retained earnings unless you specifically ask for it. However, it can be a valuable statement to have as your company grows, especially if you want to bring in outside investors or get a small business loan. Discuss your needs with your accountant or bookkeeper, because the statement of retained earnings can be a useful tool for evaluating your business growth.
Because this statement is a bit more complicated than something like a profit and loss statement, it’s important that you either get an accountant to create this for you, or if you’re preparing them yourself, to follow generally accepted accounting principles.