Definition
The Retained Earnings Formula represents the cumulative net earnings or profit of a company that it decides to reinvest in the business or pay off debt, rather than distributing it to shareholders. The basic formula is calculated by taking the beginning period retained earnings, adding the net income or loss of the period, and then subtracting any dividends paid out. This formula provides a way to understand what a company is doing with its profit or loss over a certain period.
Key Takeaways
- The Retained Earnings Formula is crucial for determining a company’s earnings that are not distributed as dividends but are retained to reinvest in the business or pay off debts.
- It either adds net income or subtracts any losses from the sum of dividends paid and the beginning retained earnings to calculate the earnings retained during a specific period. The formula is: End Retained Earnings = Beginning Retained Earnings + Net Income or Loss – Cash Dividends – Stock Dividends.
- This metric helps investors and financial analysts understand how well a company utilizes its profits for business growth. A consistent, positive retained earnings balance over time usually indicates a profitable, growing company.
Importance
The Retained Earnings Formula is important in finance as it indicates the net earnings a company has reinvested in the business or used to pay off debt, rather than distribute to shareholders as dividends.
This figure helps investors and shareholders understand how much profit a company has internally reinvested, which can be a good indicator of a company’s growth and stability.
Retained earnings can be seen as an internal source of financing for a company, they can be used for a variety of purposes like investing in new projects or expansion, paying off debts, or building an emergency fund.
As such, a consistent increase in retained earnings is typically a good sign of a company’s healthy financial status, as it suggests the company has a consistent profit margin and has the ability to self-finance any potential growth or development.
Explanation
The Retained Earnings Formula is a crucial tool in financial analysis that enables a business or organization to understand its net earnings that are held or retained within it after it has paid out dividends. This tool is particularly necessary for evaluating the financial health of a business as it assists in identifying the amount of profit a company is able to reinvest in itself or to pay off existing debts.
That is, the retained earnings formula helps reveal how much income a corporation is putting back into its operations, hence showcasing its growth potential. Notably, the retained earnings formula is also instrumental in making strategic financial decisions.
Investors typically examine the retained earnings of a business in order to assess its capacity for making dividends or other payouts. Moreover, it can also indicate to them if a company has been successful in growing its earnings over time.
Therefore, retained earnings are used as an important measure of a corporation’s long-term financial health and stability, assisting in the projection of future growth or risks.
Examples of Retained Earnings Formula
1) Amazon Inc.: If we look at the annual reports of Amazon Inc., we can illustrate the usage of the retained earnings formula. In 2019, Amazon reported net income of $6 billion and paid dividends of $0 in the same year. Meanwhile, the company’s retained earnings at the beginning of 2019 were $8 billion. Using the retained earnings formula:Retained Earnings = Beginning Retained Earnings + Net Income – DividendsRetained Earnings = $8 billion + $6 billion – $0 = $4 billionTherefore, Amazon had $4 billion in retained earnings at the end of
2) Microsoft Corporation: Microsoft reported a net income of $3 billion, and paid dividends amounting to $8 billion inSuppose, the beginning retained earnings for the year 2020 were $31 trillion. Retained Earnings = $31 trillion + $3 billion – $
8 billion = $34 trillionAt the end of 2020, Microsoft Corporation had $34 trillion in retained earnings.3) Shopify: Shopify reported a net loss of $6 million and didn’t pay any dividends inLet’s say Shopify had beginning retained earnings of $200 million inRetained Earnings = $200 million – $6 million – $0 = $
4 million. This means Shopify’s retained earnings at the end of 2020 stood at $4 million.
FAQs on Retained Earnings Formula
1. What is Retained Earnings Formula?
Retained earnings formula calculates the cumulative earnings from the firm over time that are not distributed as dividend payments to shareholders but are left to reinvest back into the business or pay off debt.
2. How is Retained Earnings Formula calculated?
Retained Earnings Formula is calculated as the beginning retained earnings plus net income minus dividends paid.
3. What is the importance of Retained Earnings Formula?
Retained earnings provide a clear picture of a company’s financial health, showing how much profit the company has reinvested in its business. It can be very useful for investors to compare retained earnings over time to understand the company’s ability to generate and use its profits efficiently.
4. What does it mean if the Retained Earnings Formula shows a negative number?
A negative retained earnings figure means the company has accumulated more debt than earnings. This is often the case with startup companies or businesses that have faced heavy losses or large dividend payouts.
5. How is Retained Earnings Formula different from Dividend Formula?
While the dividend formula calculates the portion of the company’s earnings distributed to shareholders, retained earnings formula calculates the portion of earnings kept in the business for reinvestment or debt payment.
Related Entrepreneurship Terms
- Net Income: This is the profit that a company earns after accounting for all costs, usually noted at the end of a company’s income statement.
- Dividends: These are parts of the company’s earnings distributed to shareholders, typically on a regular basis.
- Balance Sheet: It’s a financial statement summarizing a company’s assets, liabilities, and shareholders’ equity at a specific point of time.
- Shareholders’ Equity: This represents the net value of a firm, calculated as total assets minus total liabilities.
- Accumulated Earnings: These are the profits that a company has earned to date, less any dividends or distributions paid to shareholders.
Sources for More Information
- Investopedia: This is a leading finance and investing site that provides definitions, explanations and application of financial concepts, including the Retained Earnings Formula.
- Corporate Finance Institute: CFI is a certification organization for financial analysts and provides in-depth articles on a wide range of financial topics.
- AccountingCoach: This website offers free and premium accounting courses, as well as detailed explanations of accounting terms and formulas. It’s a great resource for understanding the Retained Earnings Formula.
- AccountingTools: AccountingTools provides a wide range of free information on accounting, with clear and concise explanations of important accounting concepts and procedures, including the Retained Earnings Formula.
