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In the world of bookkeeping, formulas and definitions are a dime a dozen. As an Accounting leader, It's easy to become overwhelmed, confused, and even frustrated as you try to learn them all. One of the ones you'll need to know? What is retained earnings, and how to calculate retained earnings!
Before you hop online and start Googling like crazy, read on. Today, we're sharing a quick retained earning calculator guide, helping you understand this formula and apply it moving forward.
Read on to learn more!
Abbreviated RE, retained earnings is a term used to describe the amount of net income that your company retains after it pays out dividends to its shareholders. It's possible for your business to generate positive earnings (known as profits) or negative earnings (known as losses). Positive earnings are also called a "retained surplus" or "accumulated earnings".
Why would a company choose to set aside a portion of its net profit earned through the fiscal year?
The answer is simple: This money can help fuel future growth for the organization. Business leaders can use it to:
Reinvesting this surplus back into the company is an ideal way to move it forward. Normally, company management will make the decision on whether to retain all of the earnings or distribute them back among the shareholders. Yet, shareholders do retain the right to challenge any decision to withhold surplus funds from distribution, as they are the true company owners.
If there is a high-growth project in sight, such as global expansion, both management teams and shareholders alike might prefer to retain the company earnings for a few years or more. This is especially the case if the project is slated to generate substantial returns down the road. Once those returns are realized, they could be more of a benefit to shareholders than annual dividend payouts.
This figure tells you if your business has surplus income, or if you’re operating at a loss. This helps for planning the future of the business, reinvesting - hiring talent, buying inventory, upgrading tech, etc.
This calculation can give you a quick snapshot of the cash flow and pacing of the revenue of your business. It allows you to see how much capital you have available at the end of a financial period.
It’s important to at least look at these reports at least quarterly, to monitor the pacing and performance trend of your business. This tells you if you’re on the right track! It’s important to note that you need to be looking at a long enough period that the data makes sense - as you may have larger expenses one period over another. An example would be upgrading an entire office worth of computers in Jan, but you had minimal expenses for the rest of the year. This example would make spending look out of control for Q1.
Wondering how to calculate retained earnings for a given time period? Before you begin, you'll need to know a few simple acronyms, first. These include:
Referencing the above list, the formula to calculate RE is as follows:
RE = BP + Net Income (Profit or Loss) - C - S
In some cases, organizations will combine both cash and stock dividends into one category, simply labeling it "Dividends". In that instance, the formula becomes:
RE = BP + Net Income (Profit or Loss) - Dividends
Next, let's take a look at what each of these components means and how they all work together to give you the final RE number you need.
Your company's BP refers to any surplus that it has accumulated at the beginning of the fiscal year. Instead of BP, some organizations abbreviate this term as "Beginning RE" for "Beginning Retained Earnings".
To move from the beginning RE to the final RE, you'll perform two steps. First, you'll add or subtract the profits or losses that your company made that year (its net income). Then, you'll subtract any surpluses given to shareholders in the form of dividends.
Net income reveals how your company fared financially during the applicable fiscal year. What were its total earnings?
To get this number, you'll need to subtract all of your business expenses from the revenue that your company earned that year. A few examples of the most common types of business expenses include:
If your final number is a positive one, you had a net profit. On the other hand, if your expenses exceeded your revenue, you had a net loss. You might also hear your company's net income referred to as its "bottom line". When you need it to calculate retained earnings, you can find it on your company income statement.
The final component of the retained earnings calculation refers to any dividends that your company pays out to shareholders. You'll distribute this surplus as a reward for your employees' investment in your company.
As noted in the formula, there are two different kinds of dividends that business leaders can distribute. These include:
Cash payments lead to cash outflow. You'll record such expenses in your books and accounts as net reductions, as they result in a direct company loss of liquid assets.
Stock payments, also called bonus issues, don't affect your line items in the same way. Rather than leading to a cash outflow, they simply transfer part of your retained earnings into common stock.
Say your company decides to pay one share as a dividend for every share already held by your investors. In this case, you'll reduce the price per share to half because the number of shares basically doubled. At the same time, the per-share market price will automatically adjust to accommodate the new number of shares.
How does this shift negatively affect retained earnings? While the market price adjusts on its own, the per-share valuation decreases. Your capital accounts will reflect this dip, thus impacting your RE.
Ultimately, bookkeepers must subtract both cash and stock dividends from retained earnings to maintain an accurate number in the balance sheet. The higher the dividends paid, the lower the final RE number.
As such, some growth-focused companies will restrict their dividend distribution to a very small amount, while others won't distribute them at all. This leaves more money in retained earnings that business leaders can use to fund expansion activities. More mature companies might not have long-term growth plans that are as aggressive, which can make them more generous with dividends, though the final RE is lower.
Sometimes, it helps to see a real-world example of a textbook topic. To that end, let's take a look at how a real company would calculate its retained earnings based on the formula described above. Here is the scenario:
To calculate final retained earnings for the year, Company A would perform the below calculation:
$200,000 (BP) + $20,000 (Net Income) = $220,000
$220,000 - $2,000 (Dividend) = $218,000
Of course, a positive amount is preferable when it comes to retained earnings. This reveals a trend of positive momentum in your company. In other words, it has seen more profits than losses and has accumulated the surplus over the years.
Conversely, a negative retained earnings figure shows that the company has experienced more losses than gains. This is often called an "accumulated deficit".
Want to analyze how successfully a company applied its retained earnings over time? If so, you'll use an analysis method known as Retained Earnings To Market Value.
This figure is calculated over a set period of time, usually a few years. To find it, you'll note changes in a company's stock price against the net earnings it retains.
Say, for example, that over a five-year period of September 2014 and September 2019, Company B's stock price increased from $84.12 to $132.15 per share. Throughout that same five-year period, Company B's total earnings per share were $35, and the company paid out $8 per share as a dividend.
To find the net earnings retained by the company, we'll subtract the total dividend from the total earnings per share:
$35 - $8 = $27
This means over the five-year period, Company B retained $27 earnings per share. At the same time, it's stock price rose by $48.03 ($132.15 - $84.12). We'll then divide this price rise per share by net earnings per share:
$48.03/$27 = $1.78
This indicates that for every dollar of retained earnings, Company B generated $1.78 of market value.
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