Retained earnings are the portion of a company's net income that management retains for internal operations instead of paying it to shareholders in the form of dividends. In short, retained earnings is the cumulative total of earnings that have yet to be paid to shareholders. These funds are also held in reserve to reinvest back into the company through purchases of fixed assets or to pay down debt.
For example: Let's assume you had the following numbers for a particular period:
- Beginning RE of $5,000 when the reporting period started
- $4,000 in net income at the end of the period
- $2,000 in dividends paid out during the period
To calculate the retained earnings at the end of the period:
Retained Earnings = RE Beginning Balance + Net Income (or loss) – Dividends
Retained Earnings = $5,000 + $4,000 - $2,000 = $7,000
Retained Earnings & Shareholder Equity
Retained earnings are reported under the shareholder equity section of the balance sheet while the statement of retained earnings outlines the changes in RE during the period.
A company's shareholder equity is calculated by subtracting total liabilities from its total assets. Shareholder equity represents the amount left over for shareholders if a company paid off all of its liabilities. To see how retained earnings impacts shareholders' equity, let's look at an example.
Shareholder equity is located at the bottom of the balance sheet (highlighted in blue).
- Total shareholder equity was roughly $267 billion at the end of 2017.
- Retained earnings came in at approximately $113.8 billion.
- In the upcoming quarters, any net income that's left over after paying dividends will be added to the $113.8 billion (assuming none of the existing retained earnings is spent during the quarter to pay debt or buy fixed assets).
- Both increases and decreases in retained earnings affect the value of shareholders' equity. As a result, both retained earnings and shareholders' equity are closely watched by investors and analysts since these funds are used to pay shareholders via dividends.
What Transactions Affect Retained Earnings
Revenue is the total amount of income generated by the sale of goods or services related to the company's primary operations. Revenue is the income a company generates before any expenses are taken out.
Revenue, or sometimes referred to as gross sales, affects retained earnings since any increases in revenue through sales and investments boosts profits or net income. As a result of higher net income, more money is allocated to retained earnings after any money spent on debt reduction, business investment, or dividends.
Net income will have a direct impact on retained earnings. As a result, any factors that affect net income, causing an increase or a decrease, will also ultimately affect RE.
Factors that can boost or reduce net income include:
- Revenue and sales
- Cost of goods sold, which is the direct costs attributable to the production of the goods sold in a company and includes the cost of the materials used in creating the good along with the direct labor costs involved in production
- Operating expenses, which are the costs incurred from normal business operations such as rent, equipment, inventory costs, marketing, payroll, insurance, and funds allocated for research and development
- Depreciation, which is the cost of a fixed asset spread out over its useful life
With net income, there's a direct connection to retained earnings. However, for other transactions, the impact on retained earnings is the result of an indirect relationship.
Additional paid-in capital does not directly boost retained earnings but can lead to higher RE in the long-term. Additional paid-in capital reflects the amount of equity capital that is generated by the sale of shares of stock on the primary market that exceeds its par value. The par value of a stock is the minimum value of each share as determined by the company at issuance. If a share is issued with a par value of $1 but sells for $30, the additional paid-in capital for that share is $29.
Additional paid-in capital is included in shareholder equity and can arise from issuing either preferred stock or common stock. The amount of additional paid-in capital is determined solely by the number of shares a company sells.
As a result, additional paid-in capital is the amount of equity available to fund growth. And since expansion typically leads to higher profits and higher net income in the long-term, additional paid-in capital can have a positive impact on retained earnings, albeit an indirect impact.
The Bottom Line
Retained earnings are affected by any increases or decreases in net income and dividends paid to shareholders. As a result, any items that drive net income higher or push it lower will ultimately affect retained earnings.