Understanding and Calculating Retained Earnings: A Simple Guide for Business Owners

When it comes to running a business, understanding your financial health is as crucial as having a great product or service. One key indicator of your company’s financial wellbeing is “retained earnings.” If you’re not familiar with the term, don’t worry—you’re not alone. In this post, we’ll break down what retained earnings are, how to calculate retained earnings, and why they matter for your business.

What Are Retained Earnings?

Let’s start with the basics. Retained earnings are the portion of your company’s net income that you keep in the business after paying out dividends to shareholders. Think of it as the savings account of your business. Instead of distributing all your profits, you “retain” some of it to reinvest in the business, pay off debt, or save for future needs.

But why is this important? Retained earnings offer a snapshot of your business’s financial health over time. Positive retained earnings suggest that your business is profitable and has the potential for growth. On the other hand, negative retained earnings could indicate financial challenges or a need to reassess your financial strategy.

How to Calculate Retained Earnings

Calculating retained earnings might sound intimidating, but it’s actually quite straightforward. Here’s the formula:

Retained Earnings = Beginning Retained Earnings + Net Income (or Loss) - Dividends Paid

Let’s break that down:

• Beginning Retained Earnings: This is the amount of retained earnings you had at the start of the period you’re looking at.
• Net Income (or Loss): This is your profit (or loss) during that period.
• Dividends Paid: This is the amount you’ve paid out to shareholders.

For example, let’s say you started the year with $50,000 in retained earnings. Over the year, your business made a net income of $20,000, and you paid out $5,000 in dividends. Your retained earnings at the end of the year would be:

50,000 + 20,000 - 5,000 = 65,000

So, your retained earnings are $65,000. Simple, right?

How Much Retained Earnings Does a Company Need?

Now that you know how to calculate retained earnings, the next question is, “How much retained earnings does a company need?” The answer isn’t a fixed number—it depends on several factors, such as the industry, the company’s growth goals, and its financial strategy. However, there are a few general guidelines:

• Small and Growing Companies: For startups and small businesses, it’s advisable to retain a significant portion of earnings to reinvest in the business. A good rule of thumb is to have retained earnings that can cover at least 6 months of operating expenses. This helps the company weather downturns or fund growth opportunities without taking on too much debt.
• Stable, Established Companies: For more mature companies, retained earnings may be less of a focus, as these businesses often prioritize returning profits to shareholders through dividends. However, even established companies should keep a reasonable amount of retained earnings for potential expansions or unforeseen expenses. Ideally, retained earnings should cover at least 3 to 6 months of operating costs as a financial buffer.

Here are two examples of companies with different amounts of retained earnings, each based on their stage, industry, and strategy:

Example 1: Tech Startup

• Company Overview: A software development startup in its early growth phase.
• Annual Revenue: $2 million
• Net Profit: $200,000 (10% profit margin)
• Strategy: The company is focused on scaling rapidly and investing in new features and markets.
• Retained Earnings:
  • The company retains 80% of its profits to reinvest in the business (product development, marketing, and hiring).
  • Retained Earnings: $160,000.
  • The remaining 20% is used for employee bonuses and dividends to early investors.
• Reasoning: The startup retains a high percentage of its earnings because it is in an aggressive growth phase and needs to reinvest profits to build its competitive advantage. Lower dividends are issued because investors expect long-term growth rather than immediate returns.

Example 2: Established Manufacturing Company

• Company Overview: A well-established manufacturing company that has been operating for 20 years.
• Annual Revenue: $50 million
• Net Profit: $5 million (10% profit margin)
• Strategy: The company is stable and focuses on maintaining steady operations while exploring incremental growth opportunities.
• Retained Earnings:
  • The company retains 40% of its profits for future expansion, equipment upgrades, and maintaining a cash buffer for unforeseen events.
  • Retained Earnings: $2 million.
  • The remaining 60% is distributed to shareholders as dividends and for other purposes like debt repayment.
• Reasoning: As an established company, it doesn’t need to reinvest as aggressively. Its steady cash flow and mature market position allow it to return more profit to shareholders, while still retaining a portion for potential growth and operational stability.

These examples highlight how retained earnings vary significantly based on the company’s goals, growth phase, and industry.

The Role of Retained Earnings in Financial Planning

Now that you know how to calculate retained earnings, let’s talk about why they’re important. Retained earnings are more than just a number on your balance sheet—they represent the funds you have available to grow your business.

Reinvestment and Growth: Retained earnings can be used to reinvest in your business. Whether you’re expanding your operations, purchasing new equipment, or investing in research and development, having a healthy amount of retained earnings gives you the flexibility to grow.

Debt Management: Retained earnings can also help you manage debt. Paying down loans or other liabilities can improve your company’s financial stability and reduce interest expenses, which can be a significant burden over time.

Saving for the Future: Finally, retained earnings can be saved for future needs. Whether you’re preparing for a rainy day or setting aside funds for a big opportunity down the road, having money in the bank is always a good idea.

Positive vs. Negative Retained Earnings

So, what does it mean if your retained earnings are positive or negative?

Positive Retained Earnings: If your retained earnings are positive, congratulations! This means your business is profitable, and you’ve managed to retain some of those profits for future use. Investors and lenders often see positive retained earnings as a sign of a well-managed, financially stable business.

Negative Retained Earnings: On the flip side, negative retained earnings could be a red flag. It may indicate that your business is operating at a loss or that you’re paying out more in dividends than you’re earning. While this isn’t always a cause for immediate concern, it’s something to keep an eye on. Negative retained earnings could affect your ability to secure loans or attract investors.

Reporting Retained Earnings on the Balance Sheet

Retained earnings are reported on your balance sheet, under the equity section. This placement makes sense because retained earnings represent the portion of equity that is generated from your business’s profits rather than from external investments.

For investors, the retained earnings figure is a valuable piece of information. It helps them understand how much profit is being reinvested into the company versus being distributed to shareholders.

Understanding and managing retained earnings is a key part of running a successful business. By keeping track of your retained earnings, you can make informed decisions about how to grow, manage debt, and prepare for the future. So, next time you’re looking at your financial statements, take a closer look at your retained earnings—they might just hold the key to your company’s future success.

And remember, a penny saved (or in this case, retained) is a penny earned!