Retained Earnings Formula & Explanation
Retained earnings are the cumulative profits that a company has kept to reinvest in its business. Some earnings are distributed to shareholders as dividends. The remainder is considered retained earnings.
What Retained Earnings Are
Retained earnings represent the net income retained by a company. Companies reinvest their retained earnings back into the business, often for capital expenditures, acquisitions, but sometimes also to pay off debt or hold extra working capital.
Dividend payments represent an offset to retained earnings. Dividends distribute earnings outside of a corporation, as opposed to retaining them.
Retained Earnings Formula
Retained Earnings = Cumulative Net Earnings - Cumulative Cash Dividends - Cumulative Stock Dividends
Investors can find Retained Earnings stated within a company's balance sheet. It is part of the Shareholder's Equity section.
Net Earnings are reported in the Income Statement, and Cash Dividends are reported in the "Cash Flows from Financing Activities" section of the Statement of Cash Flows. These are for the reported period, and not cumulative numbers. The amount of Stock Dividends is reported separately.
How Net Income Impacts Retained Earnings
Net income has a direct impact on the company's retained earnings. If a company incurs a net loss during a quarter, its capital base will essentially shrink as a function of the losses. Retained earnings itself can be negative if the company has incurred more net losses than net income over its lifetime (adjusted for dividends paid).
Positive net income creates profits that add to a company's capital base. The retained earnings account will reflect this increase. Of course, companies can make distributions out of their capital base, which effectively serve as deductions to the Retained Earnings account as well as the overall Shareholders' Equity of the firm.
Calculating Retained Earnings
Beginning with the previous account balance for Retained Earnings, the updated total can be calculated by adding the newly reported income for the period and subtracting paid dividends for the period.
Takeaway: Companies can use their retained earnings to invest in future growth by building new facilities, buying more equipment, launching new products, making acquisitions, or through other types of investments.
Retained Earnings Example
Let's say Acme, Inc. had $101 million in retained earnings at the end of the previous quarter. During the most recently completed quarter, the company reported $75 million in net income, and it paid $25 million in cash and stock dividends. Acme's retained earnings therefore will increase by $50 million ($75 million - $25 million) to a total of $151 million.
Cash Dividends and Retained Earnings
Companies can distribute dividends to shareholders in either cash or stock, both of which reduce the retained earnings. Since cash dividends are paid in cash, the company records them as reductions in the cash account. They are also subtracted on the balance sheet and take away from the asset value.
Stock Dividends and Retained Earnings
Stock dividends are paid in shares rather than cash, so they are accounted for by reallocating part of the retained earnings to common shares and paid-in capital accounts. Stock dividends don't affect the company's balance sheet, although they do dilute the value of the company's shares.
The impact of stock dividends is calculated by adding the value of all the shares that were distributed as dividend payments.
Tip: Although they have no direct impact on balance sheet totals, stock dividends dilute the value of the company's shares.
Retained earnings represent a company's profits minus dividends paid to shareholders. The number is calculated by taking the retained earnings from the end of the previous period, adding net income or subtracting net losses, and then subtracting any cash and stock dividends paid.
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