What are retained earnings?
Retained earnings refer to the profits remaining at the end of a business accounting period that are retained for future use. This number represents how much the business has left over after paying taxes and shareholder dividends - it’s the profit leftover that a company can use to reinvest in itself. If company growth is the priority, then dividend payouts to shareholders may be kept to a minimum. This way, the funds can be used to cover business expansion activities like:
Purchasing assets like software or equipment
Building new products
Opening new locations
Hiring new team members
Acquiring other companies
Businesses can also use retained earnings for debt payoff, which will give them the freedom to more rapidly and easily scale their operations. It’s ultimately up to management to decide how it wants to use these reserve profits, which is why it’s critical to have a carefully-managed business accounting strategy.
Retained earnings vs. revenue
Both revenue and retained earnings are financial terms that help define the success of a company.
Revenue, also known as the top line number because of it’s placement on the top of an income statement, is the total amount a company earns from its sale of goods or services. The number represents the amount earned in a given time period prior to paying operational costs and taxes. Revenue helps evaluate the performance of a company in terms of consumer demand and its ability to fulfill it. Retained earnings, on the other hand, are what is left for the business to reinvest after all required payments have been made.
Do companies have to pay taxes on retained earnings?
Retained earnings are a portion of a company’s after-tax profit. Therefore, it doesn’t pay any further tax on this sum of money: all taxes have already been paid. The company can use this money to further its business in whatever way it sees fit.
How to calculate retained earnings
The formula to calculate retained earnings is:
BP + Net - C - S = Retained earnings
To get a better understanding of what this means, we’ve included a description of each metric included in the formula:
Beginning period retained earnings (BP): The ending balance for the retained earnings from the last accounting period.
Net income or loss (Net): What remains from this period’s gross profits after all deductions are made.
Cash dividends (C): Profit revenue that is returned to shareholders or owners in the form of cash.
Stock dividends (S): Profit revenue that is returned to shareholders or owners in the form of company shares.
Even companies that don’t have investors or company shares, this is an important metric to calculate. For example, let’s say you’ve built an eCommerce website.
While every website should be managed and updated on a regular basis, eCommerce sites, in particular, require more general maintenance than some other sites. This is because inventory and pricing is always in flux. Knowing how much you have in retained earnings will be useful when it comes time to manage your inventory, hire people to help you manage the digital storefront, and so on.
It’s okay if you don’t have dividends to pay out. You’ll leave those parts out of the equation. Just keep in mind that if business owners get paid out a salary or bonus from the retained earnings, that should be included in the formula under “C”.
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The significance of retained earnings in business accounting
There’s no guarantee that a company will have retained earnings at the end of each accounting period. As income and business costs change, so do the profits a company makes.
Let’s take a look at two primary reasons why tracking retained earnings is so important: valuation and scalability.
If an accountant has no idea how much the company earns, how much it spends, and what that actually leaves the business with in terms of future spendable profits, the company could end up not having a complete understanding of its cash flow at the end of the fiscal year.
That’s just one of the reasons why the retained earnings metric is a critical one for an accountant to keep their eye on throughout the year. If the company ends up in the red (at a loss) at the end of the year and without cash to give to stakeholders or to reinvest in the company, the value of the company will drop.
Retained earnings can also provide accountants and business owners with insight into the ROI on their investments. For instance, if retained earnings from earlier in the year have been spent but the company doesn’t see greater profits from it down the road, then they’ll know to avoid that type of investment in the future.
Companies that plateau in terms of earnings put their whole operation in jeopardy. As their profits remain constant year to year, innovation will inevitably outpace them. So scaling and growing the business is a must.
That said, it’s impossible to successfully scale a business without cash, and that’s what retained earnings are for. By ensuring that the company holds onto enough funds from period to period, management can provide a more stable timeline and plan for company growth.
What’s more, the longer this growth is sustained, the more efficiently a company will be able to spend its retained earnings. This will then leave management with additional funds to reward owners, stakeholders and even employees with dividends, which is a great way to thank everyone for committing their time, effort, and, in some cases, money to the operation.