Retained earnings. While the term may conjure up images of a bunch of suits gathering around a big table to talk about stock prices, it actually does apply to small business owners.
In the post below, we’ll break retained earnings down and answer questions like:
- How do I calculate retained earnings?
- How do I find retained earnings?
- What is the retained earnings formula? How do I find beginning retained earnings?
- What’s the difference between retained earnings and revenue?
- How much should my retained earnings be?
What are retained earnings?
First things first: What are retained earnings? And maybe more importantly, why should I care?
In human terms, retained earnings are the portion of profits set aside to be reinvested in your business. In more practical terms, retained earnings are the profits your company has earned to date, less any dividends or other distributions paid to investors. Even if you don’t have any investors, it’s a valuable tool for understanding your business.
So, why should you care about retained earnings? And why should you as a busy business owner, spend time calculating them?
There are a few reasons:
- If you’re looking to bring on new investors, retained earnings are a key part of your shareholder equity and book value.
- If you’re hoping to secure a small business loan, they’re also a must.
- Retained earnings show how much capital you can reinvest in growing your business. Before you take on tasks like hiring more people or launching a product, you need a firm grasp on how much money you can actually commit.
How to find retained earnings
Retained earnings are shown in two places in your business’ financial statements:
- On the bottom line of your Income Statement (also called the Profit and Loss Statement)
- In the shareholder’s equity section of your Balance Sheet
Make sense? Excellent.
Next up: let’s go over where you can find the numbers you need and how to actually calculate your retained earnings.
How to calculate retained earnings
Now that we’re clear on what retained earnings are and why they’re important, let’s get into the math. To calculate your retained earnings, you’ll need three key pieces of information handy.
1. Find your beginning retained earnings balance
Retained earnings are calculated to-date, meaning they accrue from one period to the next. So to begin calculating your current retained earnings, you need to know what they were at the beginning of the time period you’re calculating (usually, the previous quarter or year). You can find the beginning retained earnings on your Balance Sheet for the prior period.
2. Find your net income (or loss) for the current period
Essentially, this is a fancy term for “profit.” It’s the total income left over after you’ve deducted your business expenses from total revenue or sales. You can find it on your Income Statement.
3. Find dividends paid to shareholders during the quarter or year
If your business currently pays shareholder dividends, you’ll need to subtract the total paid from your previous retained earnings balance. If you don’t pay dividends, you can ignore this part and substitute $0 for this portion of the retained earnings formula.
The retained earnings formula
Got all the numbers you need? It’s time to get out the calculator. Here’s the basic formula for calculating retained earnings:
As you can see, once you have all the data you need, it’s a pretty simple calculation—no trigonometry class flashbacks required.
Example of retained earnings calculation
Let’s take a look at an example of our formula in the real world. Malia owns a small bookstore and wants to bring on an investor to help expand the shop to multiple locations. The investor wants to know what retained earnings look like to date.
Financials for the most recent quarter look like this:
- Beginning retained earnings: $100,000
- Net income: $15,000
- Dividends paid: $10,000
So here’s Malia’s retained earnings formula: [$100,000] + [$15,000] - [$10,000] = $105,000
That means Malia has $105,000 in retained earnings to date—money Malia can use toward opening additional locations.
Another example of retained earnings calculation
Here’s another example. Herbert is the owner of Meow Bots, a startup that sells robot cats, and he wants to hire new developers. Before he can hire any new employees, Herbert needs to know how much money he has on hand to invest.
This is Meow Bots’s information for the year:
- Beginning retained earnings on January 1, 2021: $93,000
- Net income for the year ended December 31, 2021: $14,000
- Dividends paid: $22,000
So here’s Meow Bots’s retained earnings formula: [$93,000] + [$14,000] - [$22,000] = $95,000
Since Meow Bots has $95,000 in retained earnings to date, Herbert should hold off on hiring more than one developer.
What’s the difference between retained earnings and revenue?
It’s easy to get retained earnings and revenue mixed up. So what’s the difference between them?
As we mentioned above, retained earnings represent the total profit to date minus any dividends paid.
Revenue is the income that goes into your business from selling goods or services. It represents the total capital a business generates in gross sales. It doesn’t take costs, expenses, or dividends into account.
Revenue is also typically measured period-by-period. That’s distinct from retained earnings, which are calculated to-date.
How much should my retained earnings be?
Good question! If you calculated along with us during the example above, you now know what your retained earnings are. But what does that number mean? Knowing financial amounts only means something when you know what they should be.
Typically, retained earnings are judged based on their relationship to a company’s total assets. The ideal ratio between retained earnings and total assets is 1:1 (or 100 percent). However, that ratio is unrealistic for most real businesses, so don’t sweat it if you aren’t there.
The truth is, retained earnings numbers vary from business to business—there’s no one-size-fits-all number you can aim for. That said, a realistic goal is to get your ratio as close to 100 percent as you can, taking into account the averages within your industry. From there, you simply aim to improve retained earnings from period-to-period.
Are there any disadvantages of retained earnings calculations?
While understanding your retained earnings is important for business owners, and a requirement in many situations, it does have its drawbacks.
For one, retained earnings calculations can yield a skewed perspective when done quarterly. If your business is seasonal, like lawn care or snow removal, your retained earnings may fluctuate substantially from one quarter to the next. Therefore, the calculation may fail to deliver a complete picture of your finances.
The other key disadvantage occurs when your retained earnings are too high. Excessively high retained earnings can indicate your business isn’t spending efficiently or reinvesting enough in growth. Lack of reinvestment and inefficient spending can be red flags for investors, too.
That said, calculating your retained earnings is a vital part of recognizing issues like that so you can rectify them. Remember to interpret retained earnings in the context of your business realities (i.e. seasonality), and you’ll be in good shape to improve earnings and grow your business.
The information and tips shared on this blog are meant to be used as learning and personal development tools as you launch, run and grow your business. While a good place to start, these articles should not take the place of personalized advice from professionals. As our lawyers would say: “All content on Wave’s blog is intended for informational purposes only. It should not be considered legal or financial advice.” Additionally, Wave is the legal copyright holder of all materials on the blog, and others cannot re-use or publish it without our written consent.