Retained Earnings, also known as “Accumulated Earnings” and “Unappropriated Profits” is one of the most important items on the balance sheet of a business financial statement. It represents the percentage of net income that is not paid out as dividends, but instead is kept “in-house” by the company.
Any item that impacts net income or net loss will impact retained earnings. Examples of items that would impact retained earnings include: sales revenue, cost of goods sold, depreciation, and general operating expenses.
How To Calculate Retained Earnings
Retained earnings is calculated by adding the net income from the current period to the retained earnings from the previous period and then subtracting any net dividends that were paid to shareholders.
It is calculated at the end of each accounting period and is based on the previous period’s figure. The resulting number can be positive or negative, depending on the company’s net income or net loss over time. A company with negative retained earnings has failed to earn a profit for a predetermined period, and is therefore retaining its losses. Failing to make a profit is not an uncommon occurrence for a business since failures will happen from time to time. However, if a company fails to earn a profit over several successive periods, the business owner should carefully evaluate the business, their earning potential, and the ambitions of the company.
What Retained Earnings Reveal About Your Business
Retained earnings can reveal much about a company. They are an important indicator of a company’s financial health and business performance. For example, a high and positive retained earnings might be a sign that the company has a strong business plan; however, a company with a history of low retained earnings may be able to access more financing.
How Retained Earnings Can Benefit Your Business
Knowing the amount of retained earnings can help a business owner understand the financial goals of the company. If a company has a high retained earnings, the owner can decide to take a larger percentage of investment income to support the company and reduce retained earnings balances.
Rather than distributing the profits to the owners, the retained earnings can be used to reinvest in the business or to pay off any debts the company may have.
The retained earnings account is important because it shows how much profit a company has made over time and how much of that profit has been reinvested back into the company.
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The Balance Sheet is an important report in your financial statements that shows the ending balances of what you own, what you owe, and how much you have invested in your business since its inception, as at a particular date. It is divided into three (3) main categories:
Assets
Liabilities
Equities
1) Assets – What You Own
Balance sheets usually start with cash balances that include monies presently in your bank account(s) as well as your petty cash till, minus checks you may have written but are not yet presented to your bank to be cashed. Those outstanding checks would reduce your account balance(s) once they are cashed. Monies in your Paypal, Square or any other ecommerce portals that allow you to receive payments are also shown in this section of your balance sheet.
If customers owe you money that you have invoiced for but not yet received, you will see those outstanding amounts in Accounts Receivable on your balance sheet.
If you sell products, the cost of all of them that you have purchased and not yet sold will be in the Inventory Asset account.
If you own equipment, furniture, vehicle or something similar that lasts for years, you will have a balance in Fixed Assets for what you paid for these items. If it has been a while since you have owned them, you may have a Depreciation account, and when you net the two, your Fixed Asset values are reduced.
All of the above are assets and they are listed in the first section of a balance sheet.
2) Liabilities – What You Owe
If you owe money for taxes, to vendors, or to employees, then it will show in the Liabilities section, which is the second of three major sections of a balance sheet. Day to day unpaid bills are in an account called Accounts Payable, and separate accounts are usually set up to document monies owing for taxes, etc.
If you have bank loans, they usually each have a separate account like a bank account does. Each bank loan account represents the principal due on a loan (the interest you pay is recorded in the expense section of the P & L).
3) Equities – All Monies You have Invested In Your Business Plus/Minus Its Income or Loss
The final section of the balance sheet is the Owner Equities. It is the section that will vary the most depending on the type of entity your business is set up as. For example, if your business is a corporation, there will be a common stock account that will represent the original amount of money you put into the business. It will match the Articles of Incorporation that you drew up when you incorporated. This amount will rarely ever change for the life of the business.
Also, there is usually an account called Paid-in Capital which is how much additional money you have put in or taken out of the company beyond the common stock balance.
A corporation will also have a Retained Earnings account. This reflects accumulated profit (or loss) through the years of operation.
If your business is set up as a partnership, the equity section will include an account for each partner that represents their balance in the firm, which is the net amount of money they have put into the business over the years minus the amount they have withdrawn as well as plus or minus the business income or loss through the years.
Unlike the Profit and Loss or Income Statement accounts that are zeroed out at the end of each accounting period, the balance sheet accounts accumulate continuously and does not clear out at the end of each accounting period or year. Thus, the P & L or Income Statement report can be generated using specified date range while the Balance Sheet report can only be generated as at a particular ending date and not by range of dates.
