Want to get a clearer picture of how well your business is managing its profits? Then you're going to have to look at your company's retained earnings. When your business brings in money, once your expenses are covered (rent, salaries, loan payments, etc.) then some of these profits may be shared with shareholders in the form of dividends. The portion of profits that are not paid out to shareholders, but are instead held onto (or, retained) by the business are your retained earnings. Read on to find out how these retained earnings are calculated, and why they're retained in the first place.
How to Calculate Retained Earnings
When calculating retained earnings for a particular accounting period, you'll need to start with the retained earnings amount from the previous period (your "beginning retained earnings"), then add net income (or subtract net losses, which happens when your total expenses exceed your total income for a given period) and subtract any dividends paid out to shareholders.
Retained earnings = Beginning retained earnings + net income - dividends
Retained earnings = Beginning retained earnings - net losses - dividends
The result of this equation is also referred to as the retained surplus.
If you end up with a negative amount (i.e. your net losses are greater than your beginning retained earnings), this is known as a deficit, and is not a great financial position for your company to be in.
On the Balance Sheet
You will be recording your retained earnings on the balance sheet under shareholders' equity. Shareholders' equity - or owner's equity if the company is unincorporated - is part of the accounting equation.
When retained earnings are used to reinvest in the business, they are recorded as an increase in assets, or as a decrease in liabilities.
Why Retain Earnings?
We just mentioned one of the key reasons retained earnings exist: reinvestment in the business itself. What that reinvestment looks like can vary greatly depending on the size and nature of the business. If it's a manufacturing company, it could mean purchasing new equipment or putting funds toward building a new factory. Other companies may put retained earnings toward research and development.
Another major use of retained earnings is paying back debt owed by the company. (Learn all about good debt vs. bad debt.)
Building a profitable business requires lots of careful planning and requires you to keep a close eye on your company's accounting over time. Proper understanding and allocation of your retained earnings can go a long way towards making your business flourish.
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