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 are 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.
- Retained earnings (RE) is the surplus net income held in reserve—that a company can use to reinvest or to pay down debt—after it has paid out dividends to shareholders.
- When a company has positive profits, it will give some of it out to shareholders in the form of dividends, but it will also reinvest some of it back into the company for growth reasons.
- Any aspect of business that increases or decreases net income will impact retained earnings, including revenue, sales, cost of goods sold, operating expenses, depreciation, and additional paid-in capital.
How to Calculate Retained Earnings
Retained earnings (RE) are calculated by taking the beginning balance of RE and adding net income (or loss) and then subtracting out any dividends paid.
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
Shareholder Equity Impact
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 impact shareholders' equity, let's look at an example.
Below is the balance sheet for Bank of America Corporation (BAC) for the fiscal year ending in 2020. Shareholder equity is located towards the bottom of the balance sheet.
- Total shareholder equity was roughly $273 billion at the end of 2020.
- Retained earnings came in at approximately $164 billion.
- In the upcoming quarters, net income that's left over after paying dividends will be added to the $164 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.
Source: Bank of America.
What Affects 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, sometimes referred to as gross sales, affects retained earnings since any increases in revenue through sales and investments boost 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. It includes the costs of the materials used in creating the goods along with the direct labor costs involved in the 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.
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.
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
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.
Are Retained Earnings Considered a Type of Equity?
Retained earnings are usually considered a type of equity as seen by their inclusion in the shareholder's equity section of the balance sheet. Though retained earnings are not an asset, they can be used to purchase assets in order to help a company grow its business.
What Are Negative Retained Earnings?
Negative retained earnings are a sign of poor financial health as it means that a company has experienced losses in the previous year, specifically, a net income loss. One year of negative retained earnings does not signal a company in complete poor financial health, but if retained earnings have consistently been negative, then a company has not been able to generate a profit for a long time.
Do Retained Earnings Carry Over to the Next Year?
Yes, retained earnings carry over to the next year if they have not been used up by the company from paying down debt or investing back in the company. Beginning retained earnings are then included on the balance sheet for the following year.
The Bottom Line
Retained earnings are the portion of income that a business keeps for internal operations rather than paying out to shareholders as dividends. Retained earnings are directly impacted by the same items that impact net income. These include revenues, cost of goods sold, operating expenses, and depreciation.
The higher the retained earnings of a company, the stronger sign of its financial health. This indicates that a company does enough business to generate revenues that cover all expenses (and that expenses are managed efficiently), pay out dividends if the company does so, and still has money left over to invest back into itself.