How to Calculate Retained Earnings: Formula and Example

When addressing a company’s financial position and its prospects for growth, mention earned surpluses, if any, as they contribute to this aspect highly. However, for most entrepreneurs, the concept of retained earnings and their implications concerning business growth are rather abstract and perplexing. In this post, we will explain retained earnings in the simplest way possible, without hiding any details concerning the intricacies of this concept and how it can help you expand your business.

What Are Retained Earnings in Accounting?

Retained Earnings Restated: It is the element of the company profit that remains in the business instead of being paid out to the shareholders as dividends. In layman's terms, this is the residual amount after expenses, tax, and dividends have been paid out by the business. This amount is then plowed back into the firm in order to foster its expansion, settle liabilities, or support day-to-day activities.

Look at it as the organizational savings account. Just like we keep aside some part of our salary for later use, corporations also set aside some profits earned. This enabling cash ‘savings’ can assist in supporting future growth, new initiatives or crises such as economic recessions.

How Are Retained Earnings Calculated?

Calculating retained earnings is a simple process that follows this basic formula:

Retained Earnings = Beginning Retained Earnings + Net Income (or Loss) – Dividends Paid

Let’s break this down:

Beginning Retained Earnings: This is the retained earnings balance from the end of the previous period.

Net Income or Loss: This is the profit (or loss) the company made during the current period.

Dividends Paid: If the company has distributed any dividends to shareholders, these are subtracted from retained earnings.

Example:

Imagine Company X started the year with $100,000 in retained earnings. During the year, they made a net income of $50,000 and paid $10,000 in dividends to shareholders. The retained earnings calculation would look like this:

$100,000 (beginning retained earnings) + $50,000 (net income) – $10,000 (dividends) = $140,000 (retained earnings)
This means Company X has $140,000 left in the business, which they can use to fund future operations or investments.

Why Are Retained Earnings Important for Businesses?

Retained earnings are essential for a business’s long-term sustainability and growth. Here’s why:

Funding Future Growth: The Small Business Administration in a 2022 study indicated that as much as 57% of small business owners consider retained earnings to be the best form of financing for growth.

Improving Financial Stability: The process of retention of earnings acts as an insurance form, allowing the company to have some money to fall back on, in any case of bad days. This helps shield the firm from sustained losses from changes in the economy or high refers to rigid costs.

Boosting Credibility with Investors: Such a company that keeps its profit and invests shows the investors and lenders the objective of its operation is long-term growth. This is likely to improve the image of the organization and make it easier to seek funding and collaboration from other organizations.

Debt Reduction: Retained earnings can also serve to reduce the company's outstanding loans or pay the debts. Repaying these debts enhances the liability portion of a company and boosts its overall financial health.

What Factors Impact Retained Earnings?

Profitability: If the corporation reports a higher net income, then there would be more money available for retention after the declaration of dividends.

Dividend Policy: Firms that have a policy to pay a higher percentage of profit to the shareholders as dividends, will tend to have a lower retained earning.

Economic Conditions: In tough economic times, companies may experience a decline in their revenue hence a decrease in their retained earnings.

Reinvestment Decisions: In the event that a firm tends to utilize a significant portion of its retained earnings into capital-building projects on a continuous basis, then this will lead to a decrease in cash available.

Legal Requirements: There may be situations in some jurisdictions where upon the business making profits, it will be required to keep a certain percentage of that profit away from dividends.

When Should a Company Retain Earnings vs. Distribute Dividends?

The decision to retain earnings or distribute them as dividends is crucial and depends on several factors:

Growth Opportunities: If a company sees strong growth opportunities (like launching a new product or entering a new market), it’s often wiser to retain earnings for reinvestment.

Investor Expectations: Some shareholders, particularly those who rely on dividend income, may expect regular payouts. Public companies often have a balance between keeping investors happy with dividends and retaining earnings for future projects.

Financial Health: Companies with strong cash flows and stable profits may have more flexibility to distribute dividends without harming their long-term growth plans. On the other hand, if a company is trying to pay down debt or stabilize cash reserves, retaining earnings might be the smarter choice.

Tax Considerations: Retaining earnings may also help a company manage its tax obligations more effectively. By reinvesting profits instead of distributing dividends, companies may lower their taxable income, which can provide tax savings.

Can Retained Earnings Be Negative?

Even though retained earnings serve their purpose, they can also go negative owing to some reasons. This situation is also called an "accumulated deficit". This is typically observed in instances where more losses have been made over time as compared to profits earned or instances of excessive dividend payment. Such a negative retained earnings balance can be considered to pose a threat to the financial health of the entity in question, more so where it cannot even pay its creditors or fund new internal projects.

Example of Negative Retained Earnings:

A case study of negative retained earnings is General Motors (GM). Following the economic downturn of 2008, GM claimed an astonishing retained earnings deficit of USD 86 Billion owing to significant losses and downturn trends within the automobile sector. 

What Examples Illustrate Retained Earnings in Action?

Let’s look at two examples that show how companies use retained earnings:

Amazon’s Growth Through Retained Earnings

Amazon’s policy of turning profits in favor of business expansion instead of paying out dividends has been celebrated for a long time. Since its inception in 1994, Amazon has been on an aggressive reinvestment track. By the time Amazon declared its first-ever full year of profit in 2003, it was obvious that the long-term growth of the company was the primary focus and paying out dividends to shareholders was not a priority. Instead of paying dividends, earnings were plowed back into the business as expansion capital in various ways, improving e-commerce capabilities built in 1995 and 1997 to 13.7 billion acquisition deal with Whole Foods.

Perhaps one of the most crucial segments where Amazon plowed back its earnings in the reinvestment was in the building of Amazon Web Services in 2006. Today, AWS generates a substantial share of rankings profits, contributing $21.4 billion in operating income in 2021 alone. Whereas Amazon’s placating measure went a notch higher in its growth due,s its market valuation over $ 1.4 billion forecasted in the year 2024.

Apple’s Strategic Use of Retained Earnings

Apple sat on its cash and happily did not pay dividends for many years as the cash was kept to finance the company’s massive research and development (R&D) projects. For quite some time in the period between 1995 and 2012, the company did not declare any dividends, rather opted to devote extensive amounts of resources to improving R&D. Such from their own profits contained R&D reinvestment driven strategy of Apple has been paramount in revolutionary products development such as the Apple iPhone in 2007 and the Apple iPad in 2010.

Among the factors that contributed to the unimaginable growth in Apple Inc. figures in the stock market is the practice of reinvestment of retained earnings. Currently, over $27 billion is annually spent on research and development by Apple, most of which is retained earnings. This reinvestment made it possible for Apple to innovate more and more, adding new services to the ecosystem like the AppStore along with Apple Pay. In the year 2024, the company’s market value surpasses 2.8 trillion U.S. dollars making Apple the most valued company across the globe.

What Are the Common Uses of Retained Earnings?

Retained earnings can be put to various uses, each of which can have a profound impact on the business:

Expansion Projects: New projects are sustained using internal earnings to open more branches, enter new markets, or start a new line of goods.

Debt Repayment: Lowering or clearing debts using retained earnings helps in cutting down the debt burden of the company and thus the interest to be paid, stabilizing the organization.

Research and Development (R&D): Given that some industries such as information technology and pharmaceuticals rely on constant innovation, retained earnings are frequently devoted to R&D activities so as to remain within market competition and come up with newer offerings.

Stock Buybacks: Other firms prefer to use their retained earnings to repurchase equity from their shareholders. This tends to result in the increase in share price and hence the benefit of the remaining shareholders.

Operational Needs: Retained earnings are also applied for daily operational expenses in order for the business to function effectively.

How Can Outsourcing with Global FPO Help?

Global FPO understands that managing retained earnings, along with other financial aspects, requires precise planning and professional insight. By partnering with Global FPO, businesses can outsource their accounting and financial management to a team of experts who can:

• Provide accurate, up-to-date financial reporting that tracks your retained earnings.
• Help you understand when to retain earnings versus distribute dividends.
• Offer strategic advice on how to best use retained earnings for growth, expansion, or other financial goals.
• Ensure compliance with tax regulations and legal obligations related to retained earnings.
• Identify opportunities for reducing liabilities and maximizing profits through careful management of retained earnings.

Retained Earnings—Your Key to Long-Term Success

Retained earnings are not merely figures on a balance sheet, but rather are the source of growth for the business in the years to come. Essentially, it is essential for the business to comprehend how retained earnings can be used depending on when profits can be retained, and how that can put the company on a growth trajectory.
If you wish to manage retained earnings and financial strategy, Global FPO can help you today. Leave the intricacies of financial management to us while you devote your energies to expanding your business.