What are retained earnings?

Most companies are pedantic about increasing their revenue. But they’re even more concerned about profits—and, more specifically, what portion of those profits can be used for growth.

Retained earnings are that portion of profits a company keeps and doesn’t pay to shareholders.

As a business owner, you should pay attention to retained earnings because they represent the funds your company uses for growth, to pay down your debt, or save for the future.

Because it represents business financial performance over time, it’s also an important number for investors trying to gauge the financial health of your company.

Retained earnings explained

Companies focused on growth usually don’t pay dividends because their goal is to use profits to generate more income. However, many established companies that don’t expect a significant return on investment from reinvestment choose to pay a share of profits as dividends.

In such cases, retained earnings are the remaining income after the distribution of shareholder dividends. These earnings reflect the extent of a company’s ability to save net income.

Some of the projects a company may use retained earnings for include:

  • Investing into research and development for the launch of a new product
  • Merging with or acquiring competitors
  • Paying debt obligations
  • Hiring production staff to increase output and salespeople to increase turnover
  • Using for share buybacks—buying back company stock from the market

That ability to save net income and generate retained earnings is impacted by profits. If there’s decreased revenue or increased expenses, there’s less money to reinvest or distribute. On the other hand, when a company increases profits, its financing and distribution ability strengthens.

Retained earnings is essentially reserve money. It’s also known as an earnings surplus.

Retained earnings can be reported as a percentage of total earnings, known as a retention ratio.

Here’s how you calculate the retention ratio:

retention ration

If your company doesn’t make dividend payouts, the formula would be:

The retention ratio is the opposite of the dividend payout ratio, which looks at the percentage of earnings paid to shareholders. You can find the dividend payout ratio by subtracting the retention ratio in decimal form from one.

dividend payout ration

If dividends are rising at a proportionally larger amount each year compared to net income, the retention ratio will decrease. That’s an indicator the business is focusing less on growth (because more money is going to shareholders and less is being reinvested.)

Startups and smaller, growth-focused companies tend to have high retention ratios. Large companies that are already profitable and comfortable paying dividends will have a lower ratio. 

Distributing dividends reduces retained earnings, whether paid in cash or stock. When a company pays dividends in cash, it results in a net reduction. And liquid assets used for cash dividends reduce the company’s asset value, which affects retained earnings. 

A negative retained earnings is a reflection of a company’s financial performance. It usually means that revenue is too low and expenses are too high. Companies also include non-cash expenses in their income statement such as depreciation as a strategy to lower the retained earnings account 

From a reporting perspective, retained earnings are a vital connection between the income statement and the balance sheet. They’re recorded under shareholders’ equity—links both financial statements.

Key differences between retained earnings and revenue

Two essential numbers for evaluating a company’s performance are retained earnings and revenue. Both are valuable metrics for determining a company’s financial strength.

But they’re not the same thing.

1. Reporting

A company’s revenue is reported on an income statement. Revenue reflects sales for a specific period.

Retained earnings are the accumulation of net income and net losses for all the years your company has been operating. Retained earnings are reported on the balance sheet.

Accounting teams add a company’s net income from the income statement to the retained earnings so that a change reflects in the shareholders’ equity after the year has ended for the previous year

You can use ratios to gain better insight into revenue and retained earnings.

To determine the net profit margin, you would divide net income by revenue. Then multiply by 100 to turn the decimal into a percentage. This ratio will show you how much you keep out of every dollar spent. For example, if your profit margin is 25%, your company keeps $0.25 for every dollar spent.

To find the amount invested back into the company, use the retention ratio: Retained Earnings / Net Income. So, if your retained earnings are $1,000 and your net income is $12,000, your retained ratio would be 8.3%

$1,000/$12,000 x 100 = 8.3%

Keep in mind that a healthy retention ratio depends on your company’s industry.

2. Interpreting the retention ratio

Your revenue validates your business—it basically shows you the level of demand for your products and services.

Net income is the profit made after deducting all the expenses from the revenue. It’s the first component of a retained earnings calculation. Net income not paid to shareholders becomes retained earnings.

Since retained earnings accumulate, they form part of a company’s total book value. Investors can use that figure to gauge a company’s worth.

How to calculate retained earnings

Let’s look at an example to understand how to calculate retained earnings.

Company XYZ has reported figures for a three-month period ending February 28th, 2021 (figures are in thousands of dollars). While calculating retained earnings of this company, assume the beginning retained earnings balance is $0.

example of how to calculate retained earnings

Retained earnings formula

Here’s the formula you use to calculate retained earnings:

retained earnings equation

So in this case, retained earnings are: $0 + 35 – $15 = $20.

How to prepare a statement of retained earnings

Shareholders may also want to see a retained earnings statement. Let’s get into the details of how to prepare this financial statement.

1. Provide a heading

Ensure you have a three-line header on a statement of retained earnings.

  • First, mention the company’s name.
  • The second line should state ‘Statement of Retained Earnings.’
  • The third line should depict the accounting period—for example: ‘For Year Ending 2021.’
statement of retained earnings

2. Open with the balance from the previous year

The retained earnings balance of the previous year is the opening balance of the current year. It’s always the first line item. You can find the amount on the balance sheet under shareholders’ equity for the previous accounting period.

3. Include net income

Before you can include the net income in your statement of retained earnings, you need to prepare an income statement. The income statement above should serve as an example. The net income amount in the above example is the net profit line item, which is $35,000.

4. Deduct dividend payments

Based on the amount of net income earned, your company might decide to pay a certain portion to shareholders as dividends. Some companies don’t have dividend payouts—in that case, there’s nothing to subtract.

Using the above example, you would subtract $15,000 for dividend payments.

5. Calculate the balance

After inputting all the figures, you’ll be left with the total retained earnings for the year. That is your closing balance for the period.

Are retained earnings an asset?

It’s easy to mistake retained earnings for an asset because companies use them to buy inventory, equipment, and other assets. But a retained earnings account is reported on the balance sheet under the shareholders’ equity, so they’re treated as equity. The company retains the money and reinvests it—shareholders only have a claim to it when the board approves a dividend.

Notable considerations about retained earnings

Building up a retained earnings account may sound appealing, but you should keep in mind a few key points about the nature of retained earnings:

  • Retained earnings might not provide meaningful insight to investors trying to determine a company’s health during a quarter or a year, as they need to compare figures over several years to determine a company’s performance.
  • Fluctuating profits make retained earnings an uncertain source for investors to gauge a company’s performance.
  • Some companies underestimate the opportunity cost of building up retained earnings, enabling them to invest in companies or opportunities.

Use automated tracking to process expenses with ease

Retained earnings provide you with insight into your cumulative net earnings. But several financial statements need to be prepared to calculate retained earnings. One of them is the income statement, and you’ll need to process expenses to put this statement together. 

The simplest way to know your company’s financial position is with an expense management platform that tracks operational activities in one place.

Divvy’s expense management software simplifies the invoice capturing process by doing all the hard work. All you have to do is review and approve. Find out how Divvy can help you organize your financial data and save time.

To help you keep all your financial ducks in a row, Divvy offers an easy-to-use and powerful spend management platform that streamlines the process of tracking your expenses and budgets.
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