Revenue and retained earnings provide insights into a company’s financial operations. Revenue is a key component of the income statement and is also reported simultaneously on the balance sheet. Retained earnings are found from the bottom line of the income statement and then carried over to the shareholder’s equity portion of the balance sheet, where they contribute to book value.
Revenue is the income earned from the sale of goods or services a company produces. Retained earnings are the amount of net income retained by a company. Both revenue and retained earnings can be important in evaluating a company's financial management.
- Revenue is a measure showing demand for a company’s offerings.
- Retained earnings are calculated from net income on the income statement and then reported on the balance sheet within shareholders' equity.
- Over time, retained earnings are a key component of shareholder equity and the calculation of a company’s book value.
Revenue provides managers and stakeholders with a metric for evaluating the success of a company in terms of demand for its product. Revenue sits at the top of the income statement and is often referred to as the top-line number when describing a company's financial performance. Since revenue is the income earned by a company, it is the income generated before the cost of goods sold (COGS), operating expenses, capital costs, and taxes are deducted.
In most industries, gross sales are the revenue focus. Gross sales factors in COGS. Gross sales are also used for determining a gross profit margin. Gross sales represent the amount of gross revenue the company brings in from the price levels it sells its products to customers after accounting for direct COGS.
Net sales can also be a metric used for assessing revenue. Some companies, particularly in the retail industry, report net sales in place of gross sales. Net sales refers to revenue minus COGS as well as any exchanges or returns by customers during a reporting period.
Revenue on the income statement is often a focus for many stakeholders, but revenue is also captured on the balance sheet as well. Revenue on the income statement becomes an asset for a company on the balance sheet. It usually shows up in the form of cash or accounts receivable.
Companies that operate heavily on a cash basis will see large increases in cash assets with the reporting of revenue. Companies that invoice their sales for payment at a later date will report this revenue as accounts receivable. Once cash is received according to payment terms, accounts receivable is credited and cash is debited.
Retained earnings can be twofold. Retained earnings are a portion of a company's profit that is held or retained from net income at the end of a reporting period and saved for future use as shareholder’s equity. Retained earnings are also the key component of shareholder’s equity that helps a company determine its book value.
Net income is the profit earned for a period. It is calculated by subtracting all of the costs of doing business from a company’s revenue. Those costs may include COGS, as well as operating expenses such as mortgage payments, rent, utilities, payroll, and general costs. Other costs deducted from revenue to arrive at net income can also include investment losses, debt interest payments, and taxes.
Net income is the first component of a retained earnings calculation on a periodic reporting basis. Net income is often called the bottom line since it sits at the bottom of the income statement and provides detail on a company’s earnings after all expenses have been paid.
Any net income that is not paid out to shareholders at the end of a reporting period becomes retained earnings. Retained earnings are then carried over to the balance sheet where it is reported as such under shareholder’s equity.
It's important to note that retained earnings are an accumulating balance within shareholder’s equity on the balance sheet. Once retained earnings are reported on the balance sheet, it becomes a part of a company’s total book value. On the balance sheet, the retained earnings value can fluctuate from accumulation or use over many quarters or years.
Calculating Retained Earnings
Retained earnings are usually calculated by a company at the end of a quarterly reporting period. At the end of a period, distributions to shareholders are typically the only expense left that a company may incur. Distributions to shareholders are subtracted from net income to calculate retained earnings.
Balance sheet retained earnings can be calculated by taking the beginning balance of retained earnings on the balance sheet, adding the net income (or loss) for a period followed by subtracting any dividends planned to be paid to shareholders.
For example, a company has the following numbers for the current period:
- A beginning retained earnings balance of $5,000 when the reporting period began
- Net income of $4,000 for the period
- Dividends paid of $2,000
Retained earnings on the balance sheet at the end of the period are:
- Retained earnings beginning balance + net income (or loss) - dividends
- Retained earnings = $5,000 + $4,000 - $2,000 = $7,000
Retained earnings coming over from the income statement are:
- $4,000 - $2,000 = $2,000
Shareholder equity (also referred to as "shareholders' equity") usually has two basic components: retained earnings, and paid-in capital. Retained earnings are a pool of capital that has been retained over time. Paid-in capital can be capital received from investors or capital received at the time of an initial public offering. The combination of retained earnings and paid-in capital results in shareholder’s equity, which is also known as a company’s book value. Shareholder’s equity is also ascertained from subtracting liabilities from assets.
If retained earnings are generated from an individual reporting period, they are carried over to the balance sheet and increase the value of shareholder’s equity on the balance sheet overall. Thus, a company’s book value at any given time.
Comprehensively, shareholder equity and retained earnings are often seen as more of managerial performance measures. Retained earnings can affect the calculation of return on equity (ROE), which is a key metric for management performance analysis (net income / shareholder equity).
Once companies are earning a steady profit, it typically behooves them to payout dividends to their shareholders in order to keep shareholder equity at a targeted level and ROE high. This means there is usually a greater spread between net income and retained earnings for established companies.
A Final Wrap-Up
Retained earnings differ from revenue because they are derived from net income on the income statement and contribute to book value (shareholder’s equity) on the balance sheet. Revenue is shown on the top portion of the income statement and reported as assets on the balance sheet.
Revenue is heavily dependent on the demand for a company’s product. Gross revenue takes into consideration COGS. Gross revenue is the total amount of revenue generated after COGS but before any operating and capital expenses. Thus, gross revenue does not take into account a company’s ability to manage its operating and capital expenditures, though it can be affected by a company’s ability to price and manufacture its offerings.
Revenue and retained earnings are correlated to each other since a portion of revenue ultimately becomes net income and later retained earnings. The amount of profit being held in retained earnings is particularly important to shareholders since it provides insight into a company's ability to generate positive net income and return money to investors through dividends.
Ratios can be helpful for understanding both revenues and retained earnings contributions. A company can look at revenue over net income. Companies and stakeholders may also be interested in the retention ratio. The retention ratio is calculated from the difference in net income and retained earnings over net income. This shows the percentage of net income that is theoretically invested back into the company.
The amount of profit retained often provides insight into a company’s maturity. More mature companies generate higher amounts of net income and give more back to shareholders. Less mature companies need to retain more profit in shareholder’s equity for stability. On the balance sheet, companies strive to maintain at least a positive shareholder’s equity balance for solvency reporting.