How are retained earnings calculated
Retained earnings are a critical measure of a company’s financial health and growth potential. They represent the accumulated profits that a company has generated over time, but not yet distributed as dividends to shareholders. Retained earnings can be used for business reinvestment, debt repayment, or other corporate actions. In this article, we will discuss how retained earnings are calculated.
Calculating Retained Earnings
Retained earnings are computed by taking the starting balance of retained earnings from the previous fiscal period and adding the net income earned during the current period, then subtracting any dividends paid out to shareholders. The formula for calculating retained earnings is as follows:
Retained Earnings = Starting Retained Earnings + Net Income – Dividends
1. Starting Retained Earnings: This is the initial balance of retained earnings from the previous accounting period. It is found on the company’s balance sheet and serves as the starting point for measuring changes in this account.
2. Net Income: Net income refers to the company’s total revenue minus its expenses, taxes, and costs incurred during a specified accounting period. It can be found on the company’s income statement and represents the profits generated by the business operations.
3. Dividends: Dividends are payments made by a company to its shareholders, distributing a portion of its profits among them. Dividends can be paid in cash or in additional shares of stock (called stock dividends). They are typically reported on company’s cash flow statement. If no dividends are paid during the current period, this portion of the calculation would be zero.
To better understand how retained earnings are calculated, let’s consider an example:
Company A had a starting retained earnings balance of $100,000 at the beginning of their fiscal year. During that year, Company A reported net income of $50,000 on their income statement. Also, during this period, the company paid cash dividends of $20,000 to its shareholders.
Using the retained earnings formula, we can calculate Company A’s retained earnings as follows:
Retained Earnings = $100,000 (Starting Retained Earnings) + $50,000 (Net Income) – $20,000 (Dividends)
Retained Earnings = $130,000
Therefore, Company A’s retained earnings for the fiscal year stand at $130,000.
Retained earnings play a vital role in a company’s financial performance and growth strategy. They reflect the profits that have been reinvested in the business rather than distributed as dividends. By understanding how retained earnings are calculated, investors can gain insights into a company’s profitability and potential for future growth.