Revenue and retained earnings provide insights into a company’s financial performance. Revenue is a key component of the income statement. It reveals the "top line" of the company or the sales a company has made during the period. Retained earnings are an accumulation of a company's net income and net losses over all the years the business has been in operation. Retained earnings make up part of the stockholder's equity on the balance sheet.
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.
- Each period, net income from the income statement is added to the retained earnings and is 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. As a result, it 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.
Gross sales are calculated by adding all sales receipts before discounts, returns, and allowances together. Net sales are the revenues net of discounts, returns, and allowances.
Revenue on the income statement is often a focus for many stakeholders, but the impact of a company's revenues affects the balance sheet. If the company makes cash sales, a company's balance sheet reflects higher cash balances. 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 are reduced, and cash increases.
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
At each reporting date, companies add net income to the retained earnings, net of any deductions. Dividends, which are a distribution of a company's equity to the shareholders, are deducted from net income because the dividend reduces the amount of equity left in the company.
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") is made up of paid-in capital, retained earnings, and other comprehensive income. Paid-in capital comprises amounts contributed by shareholders during an equity-raising event. Other comprehensive income includes items not shown in the income statement, but which affect a company's book value of equity. Pensions and foreign exchange translations are examples of these transactions.
Since net income is added to retained earnings each period, retained earnings directly affect shareholders' equity. In turn, this affects metrics such as return on equity (ROE), or the amount of profits made per dollar of book value equity. Once companies are earning a steady profit, it typically behooves them to pay out dividends to their shareholders in order to keep shareholder equity at a targeted level and ROE high.
The Bottom Line
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.