What are retained earnings?

In bookkeeping and accounting, retained earnings (RE) represent the cumulative profits or losses of a company that have been retained in the business after paying dividends to shareholders (if applicable). Retained earnings are a component of shareholders’ equity and are found on the balance sheet under the equity section. They are an important financial metric used to assess a company’s financial health and growth potential.

Here’s how retained earnings are calculated and what they signify:

Calculation of Retained Earnings: Retained earnings at the beginning of an accounting period (usually a fiscal year) are the starting point for the calculation. To calculate retained earnings for the current period, you use the following formula:

Retained Earnings (RE)=Beginning Retained Earnings+Net Income (or Loss)−Dividends Paid−Other Adjustments

1. Beginning Retained Earnings: This represents the balance of retained earnings from the end of the previous accounting period. It is the accumulated amount of retained earnings from past years.
2. Net Income (or Loss): Net income is the profit a company has earned during the current accounting period, calculated as total revenue minus all expenses, including operating expenses, interest, taxes, and other costs. If a company incurs a net loss, this figure will be negative.
3. Dividends Paid: Dividends are distributions of profits to shareholders. If a company pays dividends during the accounting period, this amount is subtracted from the retained earnings.
4. Other Adjustments: This category may include accounting adjustments such as corrections of errors, changes in accounting policies, or other factors that impact retained earnings.

Significance of Retained Earnings:

1. Accumulated Profits/Losses: Retained earnings represent the total profits (or losses) that a company has generated and retained since its inception. They accumulate over time, reflecting the company’s financial history.
2. Source of Internal Financing: Retained earnings are a significant source of internal financing for a company’s growth and expansion. Instead of distributing all profits as dividends, a portion is retained within the company to fund investments in assets, research and development, debt reduction, or other strategic initiatives.
3. Indicator of Financial Health: The balance of retained earnings can serve as an indicator of a company’s financial health. Positive retained earnings indicate profitability, while negative retained earnings may suggest persistent losses.
4. Dividend Decisions: Companies often use the balance of retained earnings to determine the amount of dividends they can distribute to shareholders. A healthy balance of retained earnings can support regular dividend payments.
5. Investor and Lender Confidence: Investors and lenders often review retained earnings as part of their assessment of a company’s financial stability and growth prospects. A consistent increase in retained earnings can inspire confidence in the company’s financial performance.

It’s important to note that companies must adhere to legal and regulatory requirements when distributing dividends. Additionally, retained earnings can be affected by accounting adjustments and other factors, so financial analysts and stakeholders often scrutinize these figures along with other financial metrics to gain a comprehensive understanding of a company’s financial position and performance.

The role of a bookkeeper for small business includes recording income and expenses.