How to Calculate Retained Earnings – 3 Common Mistakes to AvoidWritten by Angela on May 17, 2021
If you’re a new business owner, you might not know what or how to calculate retained earnings. But now, you’re looking for some investors and they’ve asked you for it. Perhaps a mentor advised you to keep it on hand, ready for when you need it in the future.
If you’re confused about retained earnings, don’t worry! We’ll break this down for you.
Retained earnings is the amount of money that a company has left over after paying off all expenses, taxes, and any shareholder dividends. The calculation can be difficult if you aren’t careful, though–there are 3 common mistakes that people make when calculating this number.
In this article, we’ll go through how to calculate retained earnings step-by-step in order to avoid these mistakes so your business does well and stays profitable!
What is Retained Earnings?
Retained earnings refer to the portion of your profit that is not distributed as dividends but instead saved for a future need.
Even if you’re a private company, as a business owner, you might choose to take out some of your earnings for your own personal use. Whatever money you leave with the business are your retained earnings.
In the future, when you have investors and shareholders, your retained earnings will reflect the profit your business has earned that you haven’t given them as dividends.
You should maintain a healthy balance between claiming profit and keeping retained earnings. It’s tempting to cash out what you can, or make your shareholders extra happy by giving additional dividends. But if you don’t have a healthy balance, you may miss out on opportunities to grow your business.
What can you use retained earnings for?
Common Uses for Retained Earnings
Retained earnings can be used to make shareholders happy and invest in business growth, but companies with high retained earnings balances often try to find an appropriate balance between these two goals.
- You can pay off existing debts.
If you’ve taken on a business loan, you can allocate part of your retained earnings to pay off the debt and spend lower on interest payments.
- It’s easier to weather economic emergencies and downturns.
You may need a buffer to mitigate your risk for any business emergencies, or even large-scale economic downturns. The recent pandemic is a prime example for this.
- You can finance expansion plans with retained earnings.
If you need more money to expand your business operations, but don’t want or aren’t able to get a loan from a bank, then it might be possible for you to finance the expansion yourself. These can be anything from upgrading your existing equipment, opening new locations, and hiring and training new employees.
- You can fund new products and launch them.
New products can be important to your business as a means to refresh its product line or strengthen your market position. Launching new products requires additional investment in research, development, and marketing effort and tools. These can all add up to a pretty penny. If you have a healthy retained earnings balance, these can be funded easily without taking out a loan.
- You can open up new partnership opportunities.
You can generate great opportunities for your business with some solid partnerships, mergers, or acquisitions. Depending on the nature of this partnership, you may need some funds for it, which your retained earnings can happily pay for.
- If you’re publicly traded, you can repurchase shares.
To improve the value of your company stock, you may wish to repurchase shares using your retained earnings.
- You can make shareholders happier by distributing additional dividends. Whether you are your only shareholder, or you have many, keeping them happy is important to maintain your business relationship. Paying out extra dividends can improve their mood and outlook for your business.
A healthy retained earnings balance gives your business the ability to be more independent. Expansions and growth can be funded internally, instead of taking out a loan; emergencies can be managed without running to investors for help. Your business will be less reliant on external factors.
Of course, you’ll need to balance between keeping your shareholders happy and keeping sufficient reserves for emergencies and growth. Be aware that if you pay out a large amount as dividends, your balance will go down rather quickly.
Don’t forget: the larger your current balance, the more money you can budget against your business’ needs. And knowing how much you actually have is the first step.
How to Calculate Retained Earnings
It can be daunting if you’ve never calculated your retained earnings before, so we’re breaking it down for you step by step.
The basic formula for calculating it is below:
Retained Earnings = Beginning Retained Earnings
+ Net Income/Loss
– Dividends Paid
Let’s go through it one by one.
Step 1: Get your Beginning Retained Earnings balance
This is how much retained earnings you have at the start of the year (or accounting period).
Your retained earnings can be usually found on your previous year’s balance sheet, as the ending balance. This is in the Owner’s Equity section of your sheet.
You can also get your Beginning Retained Earnings balance from your general ledger, from the retained earnings section.
As you can see, you should always maintain careful accounting for your business!
Step 2: Add your Net Income/Loss from your income statement
Calculate your net income or loss for the year (or accounting period). This is added or subtracted to your opening balance.
Make sure that you record all your business expenses and revenues correctly. This ensures accurate numbers for your business.
Step 3: Subtract dividends you have paid out
If you don’t pay out dividends, you can skip this step!
Otherwise, simply subtract the amounts you have paid out to your shareholders to come up with the final number. It’s always a good idea to take note if you are taking
Step 4: Prepare your Retained Earnings Statement document
Having this prepared can help you next year or period when you need to update all your records! It’s also handy information to have when talking to possible investors.
Your Retained Earnings Statement may look like this:
Common Mistakes to Avoid When Calculating Retained Earnings
Whether you’re a seasoned business owner or just starting out, it’s possible to make mistakes when you’re preparing your Retained Earnings Statement. These errors might even happen a long time before you prepare your statement!
Take note to avoid these errors:
Mistake #1: Forgetting about depreciation
Depreciation has to be included in your net income calculation, and is therefore part of your retained earnings balance. After all, the higher your depreciation expense, the lower your net income is. This carries over to a lower retained earnings balance and lower owner’s equity.
Regardless of the method you use to calculate for depreciation, this should be reflected in your statement for accuracy. This will be important when you’re preparing your balance sheet and calculating how much of the retained earnings you can distribute to your shareholders.
Mistake #2: Not properly closing temporary accounts
If you’re recording your business’ transactions in manual ledgers, beware of not properly closing your temporary accounts. It’s important that the balances in your income statement accounts and dividend accounts are transferred to your retained earnings account.
Do this shortly after your financial statements are prepared. Otherwise, this can cause errors in your reported retained earnings for the year, and will create more errors in the current or next year’s financial reports.
Mistake #3: Not correcting errors in previous accounting periods
We’re all human, we all make mistakes. Sometimes they’re in the form of accounting errors when recording transactions for our business. But if you’ve already sent those statements out, it may be difficult to correct them.
In times like these, you should make appropriate adjustments to your retained earnings account to correct the error. This way, your Retained Earnings Statement correctly shows how your business is doing. This will help you avoid not just financial errors but also ethical ones.
Frequently Asked Questions About Retained Earnings
Retained earnings can be a little confusing especially for smaller businesses. If you’ve got some more questions about how retained earnings work, take a look at the answers we’ve got for you:
What if I don’t pay shareholders a dividend?
Don’t worry! Just skip that part of the formula completely. However, if you’re a small business and you take some of the profit, make sure it is reflected on your statement.
What does retained earnings include?
Retained earnings includes the amount of money that you made from your company. Anything that generates or uses money will change the retained earnings in a company.
This includes sales, and how much was bought to make something. It also includes operating expenses and depreciation. Retained earnings can also increase if an owner puts more money into the company.
What is the difference between net income and retained earnings?
Retained earnings comes from your net income totals for the specific accounting period, minus any dividends paid out to investors. If you do not pay out dividends, they can be the same number.
How do I record cash dividends or payouts against my retained earnings?
Since cash dividends are paid in cash on a per-share basis, simply credit the cash amount from your retained earnings account, and credit it towards your dividends payable account.
Once you distribute the dividends to your shareholders, simply debit the cash amount from the dividends payable account, and credit it towards your cash account.
What happens to my retained earnings at the end of the year?
Your retained earnings are recorded on the balance sheet as accumulated income from the previous year, including the current year’s net income or losses, and less any dividends paid out.
This amount is carried over to the next year as your Beginning Retained Earnings balance.
What is wrong if my retained earnings is negative?
If you have negative retained earnings, it means that you have more debt than earned profits for the accounting period. This means you have either exceeded the budget for paying out, or will not be able to pay out, shareholder dividends.
Does sole proprietorship businesses have retained earnings?
If you are a sole proprietor, you don’t need to keep a separate account for retained earnings since you don’t pay out dividends.
However, it is still important to keep track of your business expenditure, profit, loss, and your equity. The latter is your retained earnings. If you write yourself a check at the end of the year, your retained earnings will also be affected.
Whether you are a new or seasoned business owner, keeping track of your retained earnings is key to keeping your business healthy.
Ensuring accuracy is key to any financial task in business, including calculating your retained earnings. Consider using software for accounting, online invoicing, or financial management tools, which can minimize mistakes from happening right at the start.
Retained earnings allow you to know how much money is available in the company at any given moment. This will help you make financial projections or come up with a yearly budget for your business. You’ll be ready to invest in your business’ growth with confidence.