What is Retained Earnings?
Retained earnings (RE) is the cumulative net income that has not been paid out as dividends but instead has been reinvested in the business. For example, businesses can use these earnings to reinvest into the company for expansion through the purchase of property, plant and equipment or to pay off its debts.
Retained earnings appear on the balance sheet under shareholder’s equity. The statement of shareholders’ equity will include the changes in these earnings for a specific period.
Retained Earnings Formula
RE = Beginning period RE + Net Income/(Loss) – Cash Dividends – Stock Dividends
Net income calculation is as follows:
Ending retained earnings balance is calculated as:
Points to Note
- Retained earnings is a balance reported on the balance sheet. The calculation starts with the balance at the end of the prior year
- Net income on the income statement increases the balance
- Dividends will decrease the balance as cash falls and profit is paid out to shareholders (not invested in the company)
Impact from Net Income
Any item shown on the income statement will also impact retained earnings, for example, sales, cost of goods sold and other operating expenses. These earnings can be negative due to cumulative net losses.
Impact from Dividends
Companies can distribute cash to shareholders in the form of dividends. When companies pay cash dividends, they treat it as a cash outflow and record the impact in the cash flow from financing section of the cash flow statement. The payment of dividends will impact both the cash and retained earnings items on the balance sheet. The dividends payment causes cash to decrease with a corresponding decrease to the earnings (equity).
How Companies Use Retained Earnings
The following are some of the ways that companies can use these earnings:
- Use for a possible merger or acquisition with another company.
- Hold for share buybacks.
- Repay outstanding debts.
- Invest in a new product to expand business operations.