Definition:

Retained earnings are the accumulation of the entity’s net profit from the beginning to the reporting date after deducting the dividend payments to shareholders.

These earning are the amounts that use to distribute to shareholders or reinvests based on the entity’s dividend and investment policies.

For the entity that grows to the position that has financial healthy, dividends normally pay to shareholders.

However, for the new startup entity, they normally decide not to distribute the portion of retained earnings to shareholders.

The portion of retained earning normally uses for reinvestment as we as expended the operations, improve business and product branding, and do more research and developments.

Positive retained earnings mean that entity generated operating profits and sometimes it turns into negative. This could come from many reasons but one of the main reasons is the entity operating loss.

If the entity makes operating loss and then subsequently reduce the equity to the level that requires more fund, then the entity’s shareholders might need to inject more fund. This is depending on local regulation.

Entity’s retained earnings could be found in the entity’s balance sheet under the equity section, in the statement of change in equity or statement of retained earnings. The earning also can calculate by using the below formula.

Retain Earning Formula:

Calculate retained earnings is very straight forward. In most cases, it is shown in the entity’s balance sheet, statement of change in equity, as well as a statement of retained earnings.

Here is the formula to calculate:

Total amounts of Retained Earnings = Beginning Balance of Retained Earnings – Dividend Payments During the Year +/- Current Year Net Profit (Net Losses)

  • The total amount of Retained Earning is the total balance of earning as at the reporting date that we are looking for.
  • Beginning Balance of Retained Earning is the previous year retained earnings.
  • The entity might pay the dividend to its shareholders during the year and we must deduct these amounts from total earning
  • Total current profit or losses can find from the income statement and we must add or minus this amount from total earning.
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Statement of Retained Earnings:

The entity may prepare the statement of retained earnings in addition to the balance sheet and statement of change in equity and it is normally at the time that entity’s senior management team proposes the dividend payments to the board of directors for approval.

This statement is the extended version of the statement of change in equity and this statement show the detail of changing in retained earning of the period.

It also shows the beginning balance of earning, dividend payments, capital injection and the ending balance of earnings. The analyst prefers this statement when they perform financial statements or investment analyses related to retained earnings.

How does Net Income Affect Retained Earnings?

The total balance of retained earnings is affecting by two main important elements such as net income and dividend payment. If the entity makes the operating profit from year to year, then accumulated earning will increase subsequently.

This earning will be reduced when the entity makes the payments to its shareholders according to the board approval and dividend policies.

However, if the entity makes operating losses, then accumulated earnings will turn into accumulated losses. Capital inject may require if it reaches certain minimum amounts that limit by law.

Entity performance affects net income and net losses, and the key elements that analysts normally take into accounts including net income, cost of goods sold, operating expenses as well as interest expenses.

Sales performance increase will positively be affected to the entity bottom line but the increase must be aligned by the cost of goods sold.

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Otherwise, gross profits will reduce subsequently and then the negative effect on net income. Analyst normally investigates further on the reason that makes loss gross profit margin.

Operating expenses are also similar to the net cost of goods sold. These are what the entity pays to run its operating activities. Up normally increase in operating expenses also negatively affect net income and subsequently earnings.

Interest expenses are significantly depending on the entity’s financing strategy. If the major of entity’s fund is sourcing from loan then the interest expenses would be higher than then entity that has the high capital funding. That means for the entity that uses loans will pay more interest expenses and this will affect retained earnings.

How do Dividends Affect Retain Earning?

If you look at the formula above, you will have the idea of how the dividend would affect the retained earnings.

Normally, when the entity grows and makes profits. Then top management will consider paying the dividend to the shareholders.

This is also followed by entity dividend policies and approval from the board of directors as well as the relevant local authority.

The entity might not be able to pay the dividend to the shareholders if they don’t get the approval from the authority.

If the entity doesn’t make dividend payments, then the entity’s retained earnings will be increased cumulatively. However, if the entity makes the payments, then the portion of accumulated earnings will be reduced.

Reinvestment is not affect returned earnings but if the entity expands its operation and then turns from the net income to net losses. Then, returns earnings will be reduced subsequently.

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How to calculate retained earnings?

The following is a simple example of how to calculate retained earnings based on the information from the balance sheet and income statement.

For example, the entity’s balance sheet as of 31 December 2017 shows that beginning retained earnings amounts to USD 120,000. Since the entity makes operating profits, a board of director’s approval the dividend out to shareholders amount USD 50,000. This amount also approves by the entity’s local authority.

The entity makes a net profit after tax amounts USD 100,000 for period 01 January 2017 to 31 December 2017.

Based on this example, calculating total retained earning for year-end 31 December 2017 is quite simple. Based on the formula above, we have:

Total amounts of Retained Earnings = Beginning Balance of Retained Earnings – Dividend Payments During the Year +/- Current Year Net Profit (Net Losses)

Then, Total amounts of Retained Earnings = 120,000 – 50,000 + 100,000 = USD70,000

This means that the total retained earnings at the end of 2017 will be reduced by dividend payments that approve by board and authority amounts to USD 50,000. But, it is increased by 100,000 from entity net operating income.

This amount will become the beginning balance for year-end 2018 and the increase or decrease in 2018 will be depending on dividend payments, net income or losses that occur in 2018.