Revenue vs. Retained Earnings: An Overview
Revenue and retained earnings provide insights into a company’s financial performance. Revenue is a critical 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 operating. Retained earnings make up part of the stockholder's equity on the balance sheet.
Revenue is the income earned from selling goods or services produced. 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 and is calculated as the sum of all sales for a given period.
- Because the income statement "resets" each year, all revenue and expense activity is transferred out of nominal accounts and into real accounts on the balance sheet.
- Each period, net income from the income statement is added to the retained earnings and is reported on the balance sheet within shareholders' equity.
- Retained earnings are a key component of shareholder equity and the calculation of a company’s book value.
- Revenue is an accumulation of earnings from one specific period, while retained earnings is the accumulation of earnings across more than one period.
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. For smaller companies, this may be as easy as calculating the number of products sold by the sales price. For larger, more complex companies, this will be all units sold across all product lines.
Net sales are calculated as gross revenues net of discounts, returns, and allowances. Though gross revenue is helpful in accounting for, it may be misleading as it does not fully encapsulate the activity regarding sale activity. For example, a company may post record-level sales; however, a major recall that resulted in 10% of all sales being returned will have material consequences on net revenue.
How Is Revenue Used?
Revenue is often the first determinant in deciding how a company performed. If revenue is up, the company did great. If revenue is down, that's not the case.
Revenue is used to pay the expenses of a company. These expenses often go hand-in-hand with the manufacture and distribution of products. For example, a company may pay facilities costs for its corporate headquarters; by selling products, the company hopes to pay its facilities costs and have money left over.
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.
The critical piece to note here is that revenue does not equal cash. If a company sells a product to a customer and the customer goes bankrupt, the company technically still reports that sale as revenue. It also recognizes a loss on the cash it should have received. Therefore, revenue is only useful in determining cash flow when considering the company's ability to turnover its inventory and collect its receivables.
Revenue and retained earnings are correlated since a portion of revenue ultimately becomes net income and later retained earnings.
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.
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, and subtracting any dividends planned to be paid to shareholders.
For example, consider a company with:
- A beginning retained earnings balance of $5,000
- Net income for the period of $4,000
- Dividends paid for the period of $2,000
Retained earnings is calculated as the beginning balance ($5,000) plus net income (+$4,000) less dividends paid (-$2,000). The company would now have $7,000 of retained earnings at the end of the period.
How Are Retained Earnings Used?
Retained earnings is a figure used to analyze a company's longer-term finances. It can help determine if a company has enough money to pay its obligations and continue growing. Retained earnings can also indicate something about the maturity of a company—if the company has been in operation long enough, it may not need to hold on to these earnings. In this case, dividends can be paid out to stockholders, or extra cash might be put to use.
The amount of profit retained often provides insight into a company’s maturity. More mature companies generate more net income and give more to shareholders. Less mature companies need to retain more profit in shareholder’s equity for stability. This concept plays into value stocks and growth stocks; value stocks may be more likely to issue a dividend with excess cash if the company is more established, while growth stocks may be more likely to experience capital appreciation and deploy cash for growth.
Shareholder equity (also referred to as "shareholders' equity") is made up of paid-in capital, retained earnings, and other comprehensive income after liabilities have been paid. 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. Once companies are earning a steady profit, it typically behooves them to pay out dividends to their shareholders to keep shareholder equity at a targeted level and ROE high.
Shareholder equity is the amount invested in a business by those who hold company shares—shareholders are a public company's owners.
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 consider a company’s ability to manage its operating and capital expenditures. However, it can be affected by a company’s ability to competitively price products and manufacture its offerings.
Retained earnings is much more holistic. In addition to considering revenue, it is impacted by the company's cost of goods sold, operating expenses, taxes, interest, depreciation, and other costs. It may also be directly reduced by capital awarded to shareholders through dividends. Therefore, while the scope of revenue is more narrow, the impact to retained earnings is much more far-reaching.
Different Financial Statements
Retained earnings differ from revenue because they are reported on different financial statements. Retained earnings resides on the balance sheet in the form of residual value of the company, while revenue resides on the income statement.
Different Reporting Periods
When revenue is shown on the income statement, it is reported for a specific period often shorter than one year. A company can pull together internal reports that extend this reporting period, but revenue is often looked at on a monthly, quarterly, or annual basis. For example, companies often prepare comparative income statements to analyze reports over several years.
Retained earnings, on the other hand, are reported as a rolling total from the inception of the company. At the end of every year, the company's net income gets rolled into retained earnings. Therefore, a single number of retained earnings could contain decades of historical value accumulated over a much longer reporting period.
Different Level of Reporting (Top Level vs. Bottom Level)
It is no coincidence that revenue is reported at the top of the income statement; it is the primary driver a company's profitability and often the highest-level, most visible aspect of a company's analysis. Because expenses have yet to be deducted, revenue is the highest number reported on the income statement.
On the other hand, retained earnings is a "bottom-line" reporting account that is only calculated after all other calculations have been settled. Ending retained earnings is at the bottom of the statement of changes to retained earnings which is only assembled after net income (the "true" bottom line) has been determined.
Different Directional Strategies
Companies may have different strategic plans regarding revenue and retained earnings. Most, if not all, companies attempt to maximize revenue. Even if there are constraints or limitations to the organization, most companies will attempt to sell as much product as it can to maximize revenue.
Retained earnings isn't as straightforward as it may not be advantageous to maximize retained earnings. A company may decide it is more beneficial to return capital to shareholders in the form of dividends. A company may also decide it is more beneficial to reinvest funds into the company by acquiring capital assets or expanding operations. Most companies may argue that an idle retained earnings balance that is not being deployed over the long-term is inefficient.
Influenced by only inputs to products sold and pricing
Reported on the income statement
Is often analyzed on a shorter timeframe
Very high-level calculation that does not have many inputs
Companies often strive to maximize revenue
Influenced by all aspects of revenue and expenses
Reported on the balance sheet
Is often compiled over a longer timeframe
Very low-level calculation that is prepared after essentially all other financial records are prepared
Companies may wish to minimize retained earnings and prioritize dividends/growth
Retained Earnings vs. Net Income
Net income is the profit earned for a period. It is calculated by subtracting all the costs of doing business from a company’s revenue. Those costs may include COGS and operating expenses such as mortgage payments, rent, utilities, payroll, and general costs. Other costs deducted from revenue to arrive at net income can 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 not paid to shareholders at the end of a reporting period becomes retained earnings. Retained earnings are then carried over to the balance sheet, reported under shareholder’s equity.
How Is Retained Earnings Calculated?
You use information from the beginning and end of the period plus profits, losses, and dividends to calculate retained earnings. The formula is:
Beginning Retained Earnings + Profits/Losses - Dividends = Ending Retained Earnings.
What Is Retained Earnings on the Balance Sheet?
Retained earnings are left over profits after accounting for dividends and payouts to investors. If dividends are granted, they are generally given out after the company pays all of its other obligations, so retained earnings are what is left after expenses and distributions are paid.
What Does Retained Earnings Mean?
Retained earnings is the residual value of a company after its expenses have been paid and dividends issued to shareholders. Retained earnings represents the amount of value a company has "saved up" each year as unspent net income. Should the company decide to have expenses exceed revenue in a future year, the company can draw down retained earnings to cover the shortage.
Is Revenue More Important than Retained Earnings?
Revenue and retained earnings have different levels of importance depending on what the underlying company is trying to achieve. Revenue is incredibly important, especially for growth companies try to establish themselves in a market. However, retained earnings may be even more important for companies who have been saving capital to deploy for capital expansion or heavy investment into the business.
The Bottom Line
As a company sells products or services, it earns revenue. It uses that revenue to pay expenses and, if the company sold enough goods, it earns a profit. This profit can be carried into future periods in an accounting balance called retained earnings. While revenue focuses on the short-term earnings of a company reported on the income statement, retained earnings of a company is reported on the balance sheet as the overall residual value of the company.