How to Calculate Retained Earnings
As you review financial news or reports, you might ask questions like:
“What are retained earnings?”
“What is the retained earnings equation?”
Understanding retained earnings is an important concept in long term financial planning.
Companies need to know what their retained earnings are so they can plan for future investment, place money in rainy day funds, and the like. With that in mind, we’ll explain the concept of retained earnings and how they work on standard financial reporting.
“What is retained earnings?” is a question that anyone who runs a company should know how to answer. However, it’s easier said than done! With that in mind, we’ll also demonstrate how to calculate retained earnings.
What is the Retained Earnings Definition and the Retained Earnings Formula?
Retained earnings are the number of earnings that is left over after dividends have been paid to shareholders. This profit can be paid to shareholders but is also often used to reinvest in the business. This can be a positive or negative number, depending on business performance the prior year. We’ll show you how to calculate retained earnings with the formula below.
The retained earnings formula is as follows:
Beginning period retained earnings +/- net income or loss – cash dividends – stock dividends
What Retained Earnings Reflect about a Business
Since retained earnings are influenced by net income or loss, knowing the retained earnings number can tell you that a business may have had large net losses in the prior year. This proves how useful the retained earnings formula is.
Knowing how to find retained earnings on the income statement is important, but easy. You can usually find retained earnings at the bottom of the income statement, after all expenses and taxes.
Using Retained Earnings
A company that keeps a high amount of retained earnings most likely thinks that they can make better use of the money than by simply paying dividends, as is the case with growth-focused companies. This money often goes towards paying business expenses in the next cycle or towards reinvestment into the business.
Management and Retained Earnings
Retained earnings are traditionally used for direct business investment, such as launching new product lines, mergers and acquisitions, paying down long-term liabilities, or engaging in stock buybacks so as to increase the stock price for those who already hold shares.
In an effort to better track your overall financial performance, use Synario’s cash flow analysis. This analysis will help you accurately forecast your future financials while also providing insights regarding your cash position.
Dividends and Retained Earnings
Management can choose to pay dividends either in the form of a stock dividend or cash. These have a different effect on the balance sheet:
Cash dividends are recorded as a reduction in the cash account and are recorded as a cash outflow. Since the cash is no longer part of its liquid assets this can reduce the overall asset value of the firm.
Stock dividends on the other hand do not reduce the asset value of the firm. Instead, funds are transferred from the cash account to paid in capital and common stock based on the share price of the company when the new shares are issued. Many companies prefer this because the retained earnings stay on the balance sheet. But this does have the effect of diluting the price per share and is the reverse of a stock buyback.
Retained Earnings vs Revenue
Revenue is the most top-of-the-sheet number on a balance sheet, usually listed as gross sales or gross income. This is because this is income taken into the company before operating overhead, taxes and other expenses are taken out (i.e., pre-EIBTDA income).
Retained earnings, on the other hand, are funds kept in the house for future reinvestment and other plans, and are shown after taxes, expenses and all other factors have been removed. Some firms often prepared a retained earnings statement as part of their public tax reporting.
Limitations of Retained Earnings
Since retained earnings is an aggregate number, it can’t tell us the entire story of what is happening in a business. While a high retained earnings figure is a good indication of a company’s health, some companies can be overcautious with keeping cash in the house. The retained earnings number can’t normally tell us, for example, what returns are actually contained within the value of the retained earnings for the company.
However, a technique of estimating how well a company is utilizing it’s retained earnings is called retained earnings to market value. The technique assesses changes in stock price against a company’s net earnings.
Below is an example of determining retained earnings to market value:
Say, for example, XYZ company showed between 2012 and 2017 a stock price increase of $75 to $125, and a total earnings per share of $30, and a $15 per share dividend. The difference between the earnings per share and dividend gives us a difference of $15 per shared retained by the company over the 5-year period.
The stock also rose in price by $50 per share in the same period. If we divide this price increase by the retained earnings per share ($50/$15), we see that the company managed to create $3.33 worth of value per share with its retained earnings, based on the stock price increase.
Reach Out to Synario for Help Modeling Retained Earnings
Turbulent economic conditions and changing market landscapes can make forecasting retained earnings an increasingly difficult task. Synario allows analysts, CFOs, and stakeholders to project reliable retained earnings calculations without the hassle and maintenance of spreadsheets. Easily incorporate capital projects, economic scenarios, mergers and acquisitions, and more into your retained earnings projections with Synario’s intuitive financial modeling platform.
Synario and its platform of intelligent financial modeling tools can help you determine how to put your retained earnings to the best use. Contact us today to learn how Synario can help you understand and optimize your business.