The goal of large or small businesses is to make a profit. It is such aspirations that become the driving force of capitalism. For any businessman or individual entrepreneur, the benefit is essential. This result is the reason for opening any business (except non-profit) in the first place. Without profit, activities aimed at generating income do not make sense. To successfully promote their product on the economic market, businesses need to analyze, plan, and track a variety of indicators.
Economists from different schools can name fifteen to twenty-five different types of enterprise profits. Net profit is one of the most critical performance indicators of almost any enterprise. It includes many factors, the analysis of which allows one to manage the company more effectively. In this article, we want to review how profit is used and specifically focus on retained earnings (accumulated profit) and how to find retained earnings.
Retained earnings are the final result that the company has after paying all priority obligations and dividends. Retained earnings of the organization very often act as an indicator of the profitability of the enterprise, as well as its attractiveness to investors. Retained earnings, or rather its accounting is an essential factor in the management plans for the future of the company. Thus it is crucial to know how to find retained earnings in the first place. Distribution of retained earnings may include both existing debts to creditors and have a different focus, such as increasing working capital, expansion, and development.
How to Find Retained Earnings
Financial statements such as balance sheets, cash flow statements, and income statements, can give you a lot of information. How to find retained earnings on the financial statements? First, you should know that neither income statement nor the cash flow statement will have the retained earnings amount. This number will be indicated in the statement of retained earnings, and you can see how much it has increased or decreased compared to the previous reporting period.
However, the statement of retained earnings is not the only place where you can find retained earnings. If you look at the Shareholder’s Equity section of the balance sheet, you will see retained earnings or accumulated earnings, as they are also referred to, the amount that will coincide with the number of the RE statement. You can also calculate retained earnings on your own using retained earnings equation if you have the necessary data on hand.
Retained Earnings Formula
One would need to calculate retained earnings for several reasons. One of the main reasons is the preparation of financial statements (balance sheet, income statement, statement of retained earnings, cash flow statement). The retained earnings formula consists of retained earnings at the beginning of the reporting period (ending balance of the previous reporting period), net income or loss, and dividends paid. Using this formula, you can calculate total retained earnings as of the current reporting year and see the dynamics of it change.
Let’s review an example of how to find retained earnings. Beginning retained earnings is the balance of net profit left after dividends payment from previous years. Retained earnings of past years can accumulate. However, they are often put to use quickly. Let’s assume a company had $20,000 in retained earnings on December 31, 2018. This information can be acquired either from a balance sheet or statement of retained earnings for 2018. If there were any changes to the net income or dividends paid for the years before the reporting year, one would need to adjust the beginning retained earnings by adding or subtracting the amount of the error made.
Next, we need to add net income or loss. Companies receive the bulk of the profit (loss) from the sale of finished products, goods, works, and services. Net profit includes a part of the balance sheet profit of the enterprise from which taxes, fees, other deductions as well as expenses of the enterprise (commercial, administrative, wage expenses, etc.) are excluded. It remains entirely at the disposal of the company. From it, reserves are replenished, dividends are paid to shareholders, working capital is increased. Money can be directed towards the needs of the business, its expansion, equipment modernization, etc.
The net income value can be taken from the income statement for 2019. If you do not have the net income value, then you can use the following steps to calculate the net income or loss:
- First, calculate the profit before tax (to determine it, calculate the operating profit, which is defined as the difference between operating income and operating expenses);
- Then subtract depreciation, interest expense from operating profit;
- Lastly, subtract tax from the obtained profit value.
This will be your net income value, and you will add it to the beginning retained earnings. Thus, if a company had a net profit (income) of $150,000, a subtotal would equal to $170,000. The last step is to subtract cash and/or stock dividends.
After the Board of Directors reviews the net profit and decides how to use it, the shareholders of the enterprise usually receive their share of the benefit, the so-called dividends. Dividends are a part of a company’s profit received by shareholders in the form of cash payments or stocks. The Board of Directors determines the amount and procedure for paying dividends. In other words, bonuses are the investor’s share in the company’s profit paid to him or her as a co-owner. Dividends can turn a profit into a loss, especially if the company is in poor condition. And, finally, the remaining part of the net profit will be the retained earnings that will be spent in several possible ways.
Let’s assume the company decided to pay $50,000 in cash dividends and $15,000 in stocks. We subtract both amounts from our subtotal – $170,000 – $50,000 – $15,000 = $105,000. This is the ending amount of retained earnings for the period ending as of the end of a reporting period. This number will go into the balance sheet for 2019, and this is the same amount you will see on the retained earnings statement for 2019. Thus, our calculation of retained earnings looks like this:
RE = 20,000 + 150,000 – 50,000 – 15,000
RE = $105,000
Can retained earnings be a negative number?
Of course, retained earnings can be displayed in the balance sheet as a negative number. Moreover, it is not uncommon for start-ups. At the same time, one should not think that the existence of an uncovered loss for an enterprise is a guaranteed indicator of unreliability. For example, short-term liabilities that appeared right before the balance sheet was drawn are capable of reducing the retained earnings, or even make them harmful. Retained earnings rarely act as a sole indicator of the effectiveness of the enterprise, and more often serves as an indicator for determining investment potential.
Are retained earnings an asset or liability?
Retained earnings in the balance sheet are, of course, a liability. The value of this indicator shows the actual debt of the company to its owners since, ideally, this profit should be distributed among the shareholders and invested in the further development of the business. A company cannot manage retained earnings without the owners making a decision. Retained earnings account can be found on the liability side of the accounting equation under stockholder’s equity along with the common stock, preferred stock, paid-in capital, and treasury stock.
When are Dividend Payments Reasonable?
Reinvesting, instead of paying dividends is justified if the company’s growth rate is above average. Roughly speaking, when the growth rate of a company slows down, it’s stock price also stops growing at the same speed, and dividends will be required to keep shareholders. Such a slowdown in growth occurs with almost all companies when they achieve high market capitalization.
In this case, there will be no potential for an annual growth of 30-40%, like in a small capitalization company, no matter how much money is reinvested in it. At some point, the law of large numbers is triggered: mega capitalization and growth rates exceeding market indicators are incompatible with each other. We can observe what happens when the growth of a company is stabilized on the example of Microsoft in 2003.
In January 2003, the corporation finally announced that it would pay dividends. Microsoft has accumulated so much money in the retained earnings account that there weren’t any worthwhile projects in which to invest them. The fact that Microsoft began to pay dividends does not mean that the company is going down. This is just a sign that the company has become large and has reached a new stage, and its shares will most likely no longer double or triple in price, as before.
When deciding to pay dividends, the board, recognizes that it is better to distribute profits from the company’s activities between shareholders than to invest in the business again. In other words, the Board of Directors believes that reinvesting profits for further growth will be less beneficial to shareholders than distributing income in the form of dividends.