What are retained earnings — and why do they matter?
Owners’ equity is the difference between the assets and liabilities reported on your company’s balance sheet. It’s generally composed of two pieces: capital contributions and retained earnings. The former represents the amounts owners have paid into the business and stock repurchases, but the latter may be less familiar. Here’s an overview of what’s recorded in this account.
Statement of retained earnings
Each accounting period, the revenue and expenses reported on the income statement are “closed out” to retained earnings. This allows your business to start recording income statement transactions anew for each period.
Retained earnings represent the cumulative sum of your company’s net income from all previous periods, less all dividends (or distributions) paid to shareholders. The basic formula is:
Retained earnings = Beginning retained earnings + net income − dividends
Typically, financial statements include a statement of retained earnings that sums up how this account has changed in the current period. Net income (when revenue exceeds expenses) increases retained earnings. Conversely, dividends and net losses (when expenses exceed revenue) reduce retained earnings.
Significance of retained earnings
Lenders, investors, and other stakeholders monitor retained earnings over time. They’re an indicator of a company’s profitability and overall financial health. Moreover, retained earnings are part of owners’ equity, which is used to compute certain financial metrics. Examples include:
- Return on equity (net income/owners’ equity),
- Debt-to-equity ratio (total liabilities/owners’ equity), and
- Retention ratio (retained earnings / net income).
A business borrower may be subject to loan covenants based on these ratios. Care must be taken to stay in compliance with these agreements. Unless a lender waives a ratio-based covenant violation, it can result in penalties, higher interest rates, or even default.
Retained earnings management
Profitable businesses face tough choices about allocating retained earnings. For example, management might decide to build up a cash reserve, repay debt, fund strategic investment projects, or pay dividends to shareholders. A company with consistently mounting retained earnings signals that it’s profitable and reinvesting in the business. Conversely, consistent decreases in retained earnings may indicate mounting losses or excessive payouts to owners.
Managing retained earnings depends on many factors, including management’s plans for the business, shareholder expectations, the business stage, and expectations about future market conditions. For example, a strong retained earnings track record can attract investment capital or potential buyers if you intend to sell your business.
Warning: Excessive accumulated earnings can lead to tax issues, particularly for C corporations. Federal tax law contains provisions to prevent corporations from accumulating retained earnings beyond what’s reasonable for business needs. We can prepare detailed business plans to justify an accumulated balance and provide guidance on reasonable dividends to avoid IRS scrutiny.
For more information
Many companies consider dividend payouts and plan investment strategies at year-end. We can help determine what’s appropriate for your situation and answer any lingering questions you might have about your business’s statement of retained earnings.